The Regulatory Dilemma with Derivatives

With all that's happened in the financial markets during the last year, we now know that a large part of the banking system has slipped away into the derivatives market. To a large degree, that's become the place where the real risks of borrowing and lending are taken. As the derivatives market has evolved over the last 30 years, federal regulators have assiduously avoided regulating it (with the minor exception of standardized stock options). Instead, they believed that the private sector, aided by ratings given by the credit rating agencies, would be able to take care of itself.

Unfortunately, they seem to have forgotten the hard lessons learned in the 19th century and early 20th century: unregulated financial markets inevitably suffer boom and bust cycles. If the unregulated markets become large enough, those booms and busts will have painful repercussions for the larger economy. As somebody somewhere once more or less said, those that ignore history are doomed to repeat it. And, today, we have a repetition that would be quite familiar to J.P. Morgan himself. The mess is in the unregulated portion of the financial markets. The stock markets, which are heavily regulated, are doing okay, all things considered. This wasn't a failure of regulation. It was a failure of nonregulation.

Everyone with a seat at the table of the derivatives markets realizes that things will have to change. The Fed can't keep lowering interest rates forever, so other action will be necessary. The traditional federal approach to securities regulation--registration and extensive disclosures in prospectuses--probably won't be taken, since the SEC has backed itself into a corner. Almost all of the derivatives contracts in question were sold in ways for which the SEC does not require registration. Essentially all of the investors that invested in derivatives are so-called "accredited investors" who can purchase in these non-registered offerings. Thus, these investors did not receive the protections given to ordinary investors buying in registered offerings. While there's a nice theory that "accredited investors" (i.e., institutions and wealthy individuals) can take care of themselves, the theory had a nasty collision with reality in the mortgage and derivatives markets last year. We shouldn't delude ourselves into believing that accredited investors such as municipal officials in the American heartland or northern Norway, or thrifty dentists, really understand the nuances of the Wall Street's financial engineering. Given all the losses recently recorded by banks, it's clear that Wall Street didn't understand all of those nuances. But the SEC probably won't want to change its regulatory structure enough to bring the derivatives markets under its registration and disclosure requirements.

So what to do? Here are a few ideas.

Substantially increase capital requirements. Capital requirements for commercial and investment banks that want to play with derivatives should be sharply increased to cover the real risks that these instruments present. This will impose costs that will make the banks pause and think before creating highly risky, opaque, illiquid, and downright stupid derivatives of the sort that have caused so much trouble recently. They'll be more prudent, and that will make the banking system safer and sounder.

Create a clearing firm that processes derivatives transactions and ensures settlement. This idea is already under discussion, and the clearing firm that results should be copiously capitalized to maintain investor confidence. It's imperative to eliminate counterparty risk in the derivatives markets. Counterparty risk was the essential rationale for the Bear Stearns bailout, but the Federal Reserve can't keep bailing out every too-big-to-fail firm out there because it simply hasn't got the moola. (Okay, it could print the money for further bailouts, but then it would have to raise interest rates to counteract the inflationary potential of printing money and we all know what kind of hissy fit the financial markets would have if the Fed raised interest rates.) A soundly run clearing firm would impose high margin requirements on risky derivatives, which would make banks think closely before creating and trading these puppies. And that would make for a stronger financial system.

Tighten up the accounting rules. A number of banks may have thought that they could siphon the really nasty derivatives contracts off their balance sheets and into alphabet soup entities with names like SIVs, SPVs, conduits, etc., and therefore not maintain capital to cover the risks of these investments. Reality eventually taught them that they couldn't get away with this. The accounting rules should reflect reality; otherwise, why bother with accounting?

Apply suitability requirements to accredited investors. A lot of accredited investors who supposedly were able to take care of themselves were flimflammed in the derivatives markets. The reality is that many financial instruments today are so complex that even the people who created them don't understand them. After all, how could the grand poobah of the mortgage-backed market--Bear Stearns--have gotten itself into such a mess that it went under? Because it really didn't grasp all of the risks it took.

Suitability is a decades old concept in the securities laws that basically holds brokers responsible for selling investments that are suitable to the particular client buying them, in light of the client's wishes and circumstances. For example, it would surely violate the suitability rules to invest all of a widow's or orphan's money in an ostrich farm. It's not that much of a stretch to say that a municipality's operating funds shouldn't be invested in novel and esoteric instruments whose liquidity has never been thoroughly tested in the real world. After all, schoolchildren shouldn't be deprived of textbooks because a fast talking sales person on Wall Street earned a fat commission by selling a municipality an inappropriate investment.

In the past, many courts and arbitrators have been unenthusiastic about applying the suitability doctrine to wealthy individuals such as accredited investors, and have been even less inclined to apply it to institutional investors. That should change, at least in the context of derivatives transactions. Derivatives are products created by investment banks and the banks know much more about them than anyone else. They're in the best position to evaluate the suitability of these investments for a client, and are far more knowledgeable than any client. Many clients, even sophisticated ones, might not even know the right questions to ask. And if you don't know where to begin, you aren't likely to end up where you want to be.

Applying the suitability requirement to sales of derivatives to accredited investors would: (a) make banks pause and think before creating a piece of financial garbage that the bank wouldn't want to hold on its own balance sheet and selling it to clients; (b) result in greater disclosure to clients, which is an easier way for the regulator to foster disclosure than imposing registration requirements; and (c) make the client feel greater confidence about investing in derivatives (and investor confidence is something the derivatives markets desperately need right now). The suitability requirement wouldn't prevent sophisticated hedge funds from buying very high risk paper; but it would likely protect industrial cities in places like northern Alabama from having their budgets blown up by obscure financial risks.

Encourage increased transparency. A large part of the problem with derivatives is that you can't see them trading anywhere. Trading is done over-the-counter, which means by telephone, e-mail or other one-on-one communications not visible to anyone except the participants. This opacity is a very big reason why these puppies have become illiquid. By contrast, look at what happened to Bear Stearns' stock when the ship hit the sand--it sank dramatically in value, but trading continued and the stock never became illiquid. Let's be clear on this point: transparency enhances the true value of an investment because it reduces the scare and panic factor. Derivatives trading should be pushed as much as possible onto exchanges and other markets with public, real-time price quotations and trade reporting. Formalizing these markets will entail standardizing the various kinds of derivatives, and that will reduce broker-dealer profits. But it will enhance investor confidence, which is a higher priority than broker-dealer profits (we hope).

Stop using the credit rating agencies as pinch hitters. Up 'til now, the regulators have used the credit rating agencies, which evaluated the creditworthiness of derivatives and therefore gave investors something to rely on, as a proxy for federal regulation. That dog don't hunt no more. May we delicately observe that the credit rating agencies were perhaps a bit tardy in downgrading some derivatives? We don't want to heap too much blame on the credit rating agencies, since the primary responsibility falls on the firms that created the financial excretions we're trying to clean off the soles of our shoes. But the credit rating agencies aren't as all-knowing as many investors thought, and politically conservative federal regulators can no longer conveniently mumble ideologically-driven platitudes about the inherent superiority of the private sector over the government. The credit rating agencies evidently are trying to improve, and investors can rely on them or not, as they choose. But the United States government should stop trying to use the credit rating agencies as pinch hitters to do its job. It's time for the government to step up to the plate.

For more on the economy and economics, take a look at http://struckintraffic.blogspot.com/2008/05/american-economics-blog-carnival-june-1.html.