Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives
May 18, 2009
text-to-speech MP3 audio version.
"Kabuki is classical ancient Japanese folk theater performed broadly and loudly for the general public. I became familiar with it when I lived in Tokyo years ago. Kabuki on the Potomac this week fit Kabuki's theatrical definition with lawmakers wailing loudly, uttering angry threats, and rhythmically pounding podiums in a performance of mangled metaphors and fantasy." The Rag Blog
March 22, 2009
We gratefully acknowledge contributions for today's comment from members of the Herbert Gold Society, an informal group of current and former employees of the U.S. Treasury and the Federal Reserve System. Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps ("CDS") and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter ("OTC") derivatives. Why such a desperate battle for the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM. The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy. As we told Tim Rayment of The Times of London in his article, "Joseph Cassano: the man with the trillion-dollar price on his head," in our view AIG never had the possibility of generating sufficient income to cover its CDS contracts, thus honoring these gaming debts of AIG at face value as Tim Geithner, Ben Bernanke, et al., have done using public funds is ridiculous, even criminal. As we've said before, AIG should be in bankruptcy so that all creditors may be treated fairly - but "fairly" means a steep discount to par value without the subsidy from the Fed. Unfortunately, the Treasury and the Fed are so captured by the large banks that they will never admit the truth of what you have just read - at least so long as Geithner and Bernanke, respectively, are still in charge of the Treasury and Fed. These two fine public servants stuffed the Fed of New York with the $30 billion cost of JPM's acquisition of Bear Stearns, then used the Fed's balance sheet to float trillions of dollars more in toxic waste and bailed out AIG and its dealer counterparts for good measure. But the good deeds of Geithner and Bernanke are not yet finished. Next comes the "reform" of the OTC derivatives markets. By no coincidence, the Geithner Treasury just announced an initiative to improve the regulation of OTC derivatives. SIFMA and the large OTC dealers are making cautious noises of disapproval, but be not fooled by this Kabuki on the Potomac. As with past legislative efforts to "reform" the banking industry or protect taxpayers from large bank bailouts, the Washington game is already rigged. In that regard, read Tim Carney's comment on Treasury Secretary Tim Geithner, "Loophole Secretary," in the May 2009 issue of The American Spectator. One part of the proposal finally would improve the availability of CDS prices to the public, but in reality this "innovation" of public price transparency has been fought by the dealers for years and is small concession now. Buyers of CDS still cannot seen the best price in the markets. You have to canvas your counterparts. And of course the bid ask spread on a given contract is different with every dealer. Despite the appearance of reform, the Treasury proposal announced last week still leaves the OTC market firmly in the hands of the large derivatives dealer banks. The industry is girding for battle to make sure that the dealers keep the ball in terms of overall control of the OTC markets. Armies of lobbyists and lawyers have been marshaled by JPM, the near-monopoly player in trading and non-dealer clearing in the OTC derivatives market with nearly 50% market share and the organization with the most to lose from true regulation. It is a monument to the kindness of JPM CEO Jamie Dimon and the bank's board that they have employed a number of lobbyists formerly in the service of Fannie Mae, Freddie Mac, etc. Since the legacy GSEs, including the Federal Home Loan Banks, are buried in mounting losses and seemingly are headed for liquidation, there is not much need for lobbyists. But the New GSEs such as JPM require representation. If you have not done so, read the March 17, 2008 interview with Robert Feinberg, "GSE Nation: Interview with Robert Feinberg", where our friend and long-time observer of Washington predicted much of the response to the financial crisis, namely the embrace of the GSE model by Washington as the explicit template of choice for America. And since the largest GSEs earn a disproportionate portion of profits from unregulated OTC derivatives, managing the reform process is obviously of paramount concern. The immediate objective of JPM and the dealer community is to counter attempts to truly regulate and, most important, make standardized commodities of OTC derivatives, even as the dealers clothe the new regime proposed by Tim Geithner for clearing and trading OTC contracts in the language of reform, transparency and efficiency. Terms like innovation, productivity and competitiveness are again heard in the halls of Congress after a several months hiatus, this in connection with arguments that OTC derivatives help to manage, rather than create, risk. But the fact is that for JPM, Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and other dealers, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and American International Group (NYS:AIG) would never have failed, but without the excessive rents earned by JPM and the remaining legacy OTC dealers, they cannot survive either. Let's go back to the beginning of the story. Swaps started out in the early 1980s as a way for companies to manage financial risks. Originally swaps were private contracts, agreed to between two sophisticated parties like a bank and a large multi-national corporation. Although often described as complicated, swaps actually work on a simple principle: one party will trade the variable price of something, such as an interest rate or the price of oil, for a fixed price for that same product - that is, certainty. For example an oil refiner might agree to pay a fixed price of $50 per barrel for oil, in exchange for a bank agreeing to pay the market price for a barrel of oil. A swap agreement will provide that every six months or so for the next several years the parties will exchange payments based on their respective obligations; the refiner paying $50 to the bank, and the bank paying the then-current price of oil. The parties to a swap agreement like the one described above enter into such a contract because the customer (the oil refiner) has a real risk it is trying to manage (the price of oil). The bank facilitates the transaction to help its customer manage financial risk, which is what banks are supposed to do. But notice that at least one party to this illustrative transaction actually had an economic interest in the underlying commodity or the basis of the derivative contract. As long as private swap contracts remained individual and unique, custom tailored agreements between banks and their customers, there were few problems. In fact the ability of a company to transfer its financial risks to a bank was widely seen as a good development: the company could focus on its core business without having to worry about events beyond its control. These benefits were so obvious that the market for swaps grew rapidly with the full blessing of regulators and politicians alike. By 1999 the market had grown to have a notional value of $88 trillion dollars. But a potential problem loomed: the participants in these markets felt U.S. law was unclear as to whether the contracts were legal. This led the Clinton Administration and Congress to change U.S. law to provide special protection for swap agreements. Called the Commodity Futures Modernization Act of 2000, this law was designed to protect the ability of banks and sophisticated institutions to continue to enter into privately negotiated swap agreements. But as so often happens in Washington, the law also unleashed the growth of fully interchangeable, unregulated markets which by some measures have rendered many of the worlds largest financial institutions technically insolvent. Originally banks created swaps to help their customers manage financial risks. The contracts were a customer service, designed to enhance a bank's existing relationship with its corporate clients. But early on the banks realized they could make huge profits from small differences in the prices they charged different customers entering into the agreements. Thus was born the deliberately opaque and secretive inter-dealer world of CDS, the market between and among the dealers themselves, which has become an engine for manufacturing the appearance of profits - even while increasing systemic risk. As the demand for swaps increased, banks learned they could effectively take the fixed value they received from one customer and pass it onto another, keeping a small piece of the action. In effect the banks turned into riskless middlemen, profiting by matching buyers and sellers. This was, in part, the opportunity that would lure AIG, a huge seller of credit default swaps, to its destruction. (See our previous comment on AIG, "AIG: Before Credit Default Swaps, There Was Reinsurance", April 2, 2009. But to maximize their profits, the banks needed to make sure all their contracts matched. So they changed the private, customized nature of swaps into standardized contracts that could be easily traded throughout the financial system. There was nothing new about this type of business. In fact stock exchanges operate on exactly the same principle. But exchanges are fully regulated, with collateral and margin requirements enforced by the clearing members. Moreover, to protect customers and the public, exchanges make sure everyone plays by the same set of rules and receives the same treatment. That means equal access to such important protections as the ability to see what the market price is for a security and the assurance that the market will honor your trade even if your counterparty can't. The swaps market, originally designed for a world where banks negotiated private agreements with their customers, has none of these basic market protections and arguably is deceptive by design, placing customers at the mercy of the large derivatives dealers. In 2005, the New York Fed began to fear that the OTC derivatives market, at that time with a notional value of over $400 trillion dollars, was a sloppy mess - and it was. Encouraged by the Congress and regulators in Washington, the OTC market was a threat to the solvency of the entire global financial system - and supervisory personnel in the field and the Fed and other agencies had been raising the issue for years - all to no effect. This is part of the reason why we recommended to the Senate Banking Committee earlier this year that the Fed be completely relieved of responsibility for supervising banks and other financial institutions. Parties were not properly documenting trades and collateral practices were ad hoc, for example. To address these problems, the Fed of New York began working with 11 of the largest dealer firms, including Bear Stearns, Merrill Lynch, Lehman, C, JPM, Credit Suisse and GS. Among the "solutions" arrived at by these talks was the creation of a clearinghouse to reduce counterparty credit risk and serve as the intermediary to every trade. The fact that such mechanism already existed in the regulated, public markets and exchanges did not prevent the Fed and OTC dealers from leading a multi-year effort to study the problem further - again, dragging their collective feet to maximize the earnings made from the existing OTC market before the inevitable regulatory clampdown. For example, in the futures markets, a buyer and seller agreeing to a transaction will submit it to a clearing member, which forwards it to the clearinghouse. As the sell-side counterparty to the buyer and the buy-side counterparty to the seller, the clearinghouse assumes the risk that a party to the transaction might fail to pay on its obligations.. It can do this because it is fully regulated and by well capitalized. As the Chicago Mercantile Exchange is fond of saying, in 110 years no futures clearinghouse has ever defaulted. While the NY Fed believed that a central counterparty was necessary to reduce risks that a major OTC dealer firm might default, the banks firmly resisted the notion. After all, they make billions of dollars each year on the cash and securities which they required their hedge fund, pension fund and other swap counterparties to put up as collateral. Re-pledging or loaning these customer securities to other clients is very lucrative for the dealers and losing control over the clients collateral would dramatically impact large bank profits. A clearinghouse would eliminate the need for counterparties to post collateral and a lucrative source of revenue for the dealer firms. So they bought the Clearing Corporation, an inactive company that had been the clearinghouse for the Chicago Board of Trade. If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the logic of the GSE mindset. Meanwhile, other viable candidates for OTC derivatives clearing were eager to get into the business, such as the Chicago Mercantile Exchange and the New York Stock Exchange. Both had over 200 years experience in clearing trades and were well suited to serve as the impartial central counterparty to the banks and their customers. If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing. Therefore, they sold The Clearing Corp. to the Intercontinental Exchange, or ICE, a recent start-up in the OTC derivatives business which had been funded with money originally provided by, you guessed it, the banks. In the deal with ICE, the banks receive half the profit of all trades cleared through the company. And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings. That's right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units. Note that the FRBNY forced the approval of ICE through as "bank," another obvious power grab (include it with the insurance companies, etc). Some internal Board staff argued that this closed, Sell-Side counterparty was not the optimal market solution, but instead allowed the preservation of the dealer oligopoly in CDS. For the dealers, it was the least bad solution that gave Geithner, FRBNY OTC market risk honcho Theo Lubke and the staff of the FRBNY something they could tout as progress. But what it has done is taken too-big-to-fail banks (which aren't) and bound them together in a too-big-to fail central counterparty for CDS!. Why is ICE styled as a NY state bank again? The Fed waived bank capital requirements. In fact, this "special" bank doesn't even have to report the ratios to the Fed as do other banks, an amazing concession which allows everything to be kept secret. If ICE didn't want to be a bank, it shouldn't have asked for a bank charter, but the Fed's accommodation of ICE and the dealers that control it should forever put to rest the notion that the Fed board is able to act independently when it comes to safety and soundness regulation. If this new central counterparty is so transparent, when are ICE and the dealers going to publish the margin methodology and the central guarantee fund methodology? We understand that each counterparty uses the same portfolio (parametric) VaR method to calculate required margin. The same VaR calculation at a somewhat higher confidence then gives the guarantee fund contribution requirements. Doesn't anyone remember that VaR is pro-cyclical and is reliant on historical volatilities and correlations? This "new" system is game-able from day one. Dealers facing margin calls could actually sell more protection in names that have been historically negatively correlated to reduce margins. That's right... sell more protection on an absolute basis to reduce the margin requirements. But don't worry; the crack NYFRB team is looking at the models -- just like they were looking at C models and rated everything satisfactory. The good people the NYFRB had in charge of market risk supervision in recent years never built or ran a commercial VaR model in their lives. Maybe these are the same folks who kept asking us about the Economic Capital model in the IRA Bank Monitor, even after we showed them the page in the textbook. We hear that the FRBNY supervision "SWAT team" has been a rotation of non-experts, apparently purposefully, who are very similar to the crowd around Secretary Geithner at Treasury in Washington. And neither the FRBNY nor the Treasury ever listen to people inside the Fed that have actual market experience. These are academic, monetary economists by and large, not technocrats. Power, control and information rule the day -- not competence nor concern about the effectiveness of policy. After the VaR based guarantee fund there is a "commitment" by each ICE dealer to pony up more in case the guarantee fund is fully drawn. A commitment from banks under severe stress to save each other -- how much is that worth? A bank in that situation has to make the best business decision for its shareholders, and that could very well be to walk away from any commitment to dump billions into ICE because a competitor fails. Has the Fed learned nothing? At least each of the sell-side counterparties in the group knows the parameters of the margining and how it could go awry. The outside world, the un-favored counterparties to the dealers, have no idea how good or bad the margins and commitments might ultimately be for them. It's in Fed they trust - because they have no choice. An open exchange with a set of transparent rules, margin requirements, and price discovery is the optimal solution. Why the Fed would push through something else is clear -- it is in bed with the dealers. Confused yet? The Fed and the dealer banks sure hope so, because it makes it less likely you will fully grasp their stranglehold on the OTC markets. In order to ensure that the OTC business never left their grasp they made sure the ICE-TCC entity was formed as a bank, regulated by the NY Fed; the harder for their regulator to object. Then to top it off, the banks told the regulators that they would report all their trades through a so called central trade repository, the Trade Information Warehouse. This entity is owned by an outfit called the Depository Trust Clearing Corporation; all you need to know about DTCC in the global clearing system is that it too is controlled by the banks. Indeed, the DTCC is a Fed member bank. While many of the initiatives taken by the DTCC over the past half decade to improve the OTC markets are laudable, they must all be seen in the context of the DTCC's place within the community of dealer banks. Moreover, to protect their monopoly in derivatives, the banks are lobbying Congress and the Obama Administration to require that anyone that wants to engage in the OTC derivatives business must be, wait for it . . . a bank. The banks are selling this idea under the rubric of creating a "systemic risk regulator," a powerful federal agency with the power to see across markets and participants in order to identify and forestall systemic risk. Reaching new heights of disingenuousness, the OTC dealer banks propose that the Federal Reserve, their regulator and the agency that missed every sign leading up to the present financial collapse, the cheerleader for the banks, become the systemic risk regulator. By proposing that anyone engaging in the OTC business must be a bank, the banks would ensure that their regulation wouldn't change in any way. But their potential competitors in this area, such as energy companies, hedge funds and commodity firms, would effectively be pushed out of the business. That is the little surprise that the Fed and Treasury have for Buy Side funds in the OTC reform legislation. House Agriculture Committee Chairman Colin Peterson (D-MN) and Senate Banking ranking member Richard Shelby (R-AL), seem to see the Geithner reform plan for OTC derivatives for what it is, namely a proposal by and for the large banks. But others, such as House Financial Services Committee Chairman Barney Frank (D-MA), appear all too eager to do something, anything, to address this complex issue -- no matter how misguided or anti-competitive it might be. Frank's continuing infatuation with the Fed as the center of the regulatory universe is a subject of quiet wonderment by even some Democrats on the committee, but none are yet willing to challenge the temperamental and volatile Frank. Even worse, with the US taxpayer now owning substantial stakes in most of the large dealer banks, what incentive does the US Treasury have to eliminate the banks' last truly lucrative monopoly? In a very real sense, without the excess rents earned from the OTC markets, large dealers such as JPM, C and GS might not be viable in their present form. Remember, on a nominal basis, OTC derivatives appear to be the most profitable activity of many large banks. It is only when you assess the OTC derivatives dealing activity of large banks on a risk-adjusted basis does the value destruction become apparent. One can only hope that reason will prevail, especially the version of reason that now prevails in the Senate, where there is little illusion about the true nature of the relationship between the large OTC dealer banks, the Fed and the Treasury. True reform of the OTC space would force most derivatives on exchange while leaving the banks free to offer customized risk management contracts to their customers, subject to stringent capital requirements. But JPM and the other OTC dealer banks will fight to their last taxpayer dollar to stop that from happening. The only question now is whether the smaller banks, and the large Buy Side and other non-bank participants in the OTC markets, including some of the largest investment, industrial and energy firms in the world, can deliver the message to Washington that the current reform proposals for OTC derivatives are ill-advised and contrary to the public interest.Questions? Comments? email@example.com
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