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September 22nd, 2011

Bank gambling raises mortgage rates

by Peter Miller


iStock_Rolling the DiceIn scenic Switzerland, the largest bank in the country, UBS, has just announced that it “has discovered a loss due to unauthorized trading by a trader in its Investment Bank.”

OK, so how much could one rogue trader possibly lose? According to UBS, the current estimate is “in the range” of $2 billion.

Initial reports allege that the UBS employee was involved with Exchange Traded Funds:

ETF’s are a type of tradeable share that track movements in other indexes or commodities, and can be affected by short-term volatility in prices.

The UBS story–which is unfolding as this is written–is not an isolated event nor is it likely to be the largest loss associated with a bank trader. Jerome Kerviel, formerly with Societe Generale, allegedly made unauthorized trades that cost the bank about $6.6 billion.

Rogue traders

We like to label people in the news who lose big amounts of money allegedly without authorization as “rogue” traders, but we ought to be more concerned about the executives who simply make approved-but-woeful decisions.

After all, someone at the Bank of America though the purchase of Countrywide and Merrill Lynch were a great idea. A stock that was above $50 a share in 2007 now trades for $7–and this was done without help from any rogue traders.

Mortgage rates could be even lower

Tim Manni—the editor and other author of this blog–says mortgage rates have been at record lows and explains that “while it’s certainly not breaking news at this juncture, it goes without saying that with every new venture into record-low territory, at least some qualifying borrowers are getting the opportunity of a lifetime.”

It also goes without saying that mortgage rates would likely be lower and even more people would benefit if there was less risk in the system.

Given that our banking system is so fragile, why do we allow commodities and derivatives trading?

Wall Street reform

Under recent Wall Street reform, there’s supposed to be less opportunity for commodities fraud because banks are not supposed to use their own money in such transactions. That’s a nice thought, but the rule does not go into effect until mid-2012 giving rouge traders lots of time to fudge their numbers. Right now banks are allowed to use their own funds for commodity and derivative trading.

This may not sound like a big deal until we consider the idea of leverage.

According to the Financial Policy Center:

Instead of buying $1 million of Treasury bonds or $1 million of stock, an investor can buy futures contracts on $1 million of the bonds or stocks with only a few thousand dollars of capital committed as margin (the capital commitment is even smaller in the over-the-counter derivatives markets). The returns from holding the stocks or bonds will be the same as holding the futures on the stocks or bonds. This allows an investor to earn a much higher rate of return on their capital by taking on a much larger amount of risk.

Well, yes, an investor can earn a much higher rate of return if their bet is right. If their bet is wrong, then losses are magnified.

If there is anything the UBS story tells us–and if there are any lessons from past takes of “rogue” traders–it’s that banks should not be allowed to be in the leveraged betting business. That may seem unfair, but only if you think that mortgage rates should be higher because banks are allowed to gamble.

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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