Derivatives Dealers Grumpy Over Deutsche Bank Ruling

Derivatives dealers worldwide are grumpy because of a ruling by the highest civil court in Germany finding that Deutsche Bank AG was responsible for disclosing the risks of a derivatives transaction to a company that bought an interest rate swap. The German court was concerned by the bank's conflict of interest from the risks in the transaction being stacked in its favor, at the customer's expense. The court especially didn't like the bank's failure to disclose that the customer's starting value in the transaction was an unrealized loss of -80,000 Euros, or over -$100,000. The court noted that although Deutsche Bank had warned the client that the risk of loss was theoretically infinite, it also predicted that the transaction would be profitable for the customer. The court thought the bank should have made loud and clear that the customer's losses could really be costly, and not just theoretically so. (See Wall Street Journal, Dec. 23, 2011, P. C3).

From a derivatives dealer's standpoint, disclosure obligations like those required by the German court seriously erode the dealer's informational advantage. In the financial markets, an informational advantage is more valuable than gold. That's why, as illustrated by the U.S. government's investigation into trading by hedge fund manager Galleon Group and others, there is so much apparent insider trading. Having the informational advantage really pays. If derivatives dealers now have to make disclosures as contemplated by the German ruling, bank profits might suffer. And nothing, as we all know, could be more horrifying than that.

The U.S. SEC's 2010 case against Goldman Sachs for its role in a mortgage-related derivatives transaction called Abacus 2007-AC1 crimped the style of banks acting as underwriters. The German court's ruling may have a bigger day-to-day impact, since it concerns a bank acting as a dealer in the interest rate swaps market. Trillions of dollars of transactions per month take place in this market. Banks are dealers--i.e., they act as principal on one side or the other of the swap--because customers don't want the credit risk of any counterparty other than a very large (and de facto government guaranteed bank). Too-large-to-fail banks of commercially powerful nations like Germany and the U.S. have an advantage in this market, since their governments' implicit guarantees are worth much more than, say, the Greek or Dubai government's guarantee. If the laws of commercially powerful nations like Germany and the U.S. begin to tilt the derivatives playing field toward anything approaching level, the banks may seek more accommodating nations in which to ply their derivatives trade. But, as financial markets globalize, there will be fewer and fewer places for big banks to go. And increasingly savvy corporate clients may abjure from doing transactions routed through a Caribbean island or Equatorial African nation.

Progress on the regulatory reforms in the Dodd-Frank financial legislation enacted last year has, on the best of days, been confined to the slow lane. Big banks have lobbied combatively to limit and water down the changes. The SEC has long known of the informational disparity in the derivatives market, having brought an enforcement case in 1994 that illustrated the problem. See http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html. Perhaps the German court's decision will help to encourage U.S. regulators to push through the headwinds of the big bank lobbying juggernaut. Some of the big banks' corporate customers have been convinced to lobby against change. But the German case, and the SEC's 2010 and 1994 cases, reveal that corporate customers sometimes don't even know what they don't know. It's one thing to let people knowingly take risks. It's another thing to leave them unknowing and saddled with risk.

How Banks Took Derivatives Too Far

We’ve recently learned that major banks guaranteed the value of some of the derivatives they sold. Hedge funds were promised that if CDO interests that they bought fell below a certain value, the bank selling the interests would buy them back at a guaranteed price. Asset-backed commercial paper issued by bank-affiliated SIVs was 10% to 50% guaranteed by the banks sponsoring the SIVs.

More recently, it was reported in the Wall Street Journal (11/1/07, P. C3), that some money market funds that invest primarily in tax-exempt securities (i.e., municipal securities) bought short term, tax-exempt investments through so-called “tender-option bond programs.” These investments were derivatives synthesized from long term municipal bonds into short term investments that money market funds could purchase. Some of these synthetic instruments, however, were given low investment ratings, and Merrill Lynch, which underwrote these puppies, guaranteed to pay them if the underlying municipal bonds didn’t pay in full. Some money market funds, nervous about Merrill’s recently announced losses, have sold their holdings back to Merrill, not wanting to find out later whether its ability to honor its guarantee will hold up.

CDO interests; asset-backed commercial paper; now synthetic tax-exempt investments. All of a sudden, this isn’t very much fun any more. How much of the derivatives market have the banks guaranteed? Have they guaranteed other types of derivatives? Are their balance sheets and income statements accurate? Have they fully disclosed the risks from these guarantees? With all these contingent liabilities, are there questions about the safety and soundness of some major banks?

This adds to the cognitive dissonance already abundant in the financial markets. The Norman Rockwell version of the derivatives market is that it consists of a bunch of freckle-faced kids sipping frappes and trading contracts that repackage and shift risk to parties that choose to bear it. Volatility is supposedly damped. Market efficiency is supposedly enhanced. Smiles spread across many faces.

But these guarantees don’t shift risk. They retain it. The banks offering the guarantees were, in essence, giving the investors a put option, the ability to offload the derivative in case it turned out to be a turkey. Risk wasn’t shifted. Volatility, as we now know, has been exacerbated. Market efficiency, as we now know in spades, has been undermined by the credit crunch. Smiles are few and far between.

If these deals were so bad for the banks, then why did the banks do them? In a word: fees.

The banks got underwriting, advisory, servicing and perhaps other fees for doing derivatives offerings. Fee income came into vogue for commercial banks over the last 15 years, as risk-based capital requirements were gradually implemented. Banks were encouraged to offload the risks of commercial lending and make their money as intermediaries in the credit process. Fees were supposed to be a low risk way of making profits. That’s one of the reasons why you’re clobbered with charges for being one hour late in paying your monthly credit card statement, going $1 over your credit limit, and bouncing a check even one time after 10 years as a loyal customer. Banks love fee income, much more than they love having you as a customer. Investment banks love fee income, too, especially if they aren’t proprietary trading powerhouses.

Smackdowns of retail banking customers generate fees at a clip of $20 or $30 at a time. If you trample a large enough number of customers, it becomes real money. But derivatives deals provide millions of dollars of fees and other compensation per deal, a seemingly more efficient way to make money. Like moths drawn toward a flame, the banks moved into the derivatives market in their usual herd-like fashion, and did deals in abundance.

Evidently, they found the going tougher than expected. Some money managers, it would appear, realized that there were worms in them thar cans they were buying, and negotiated guarantees. The guarantor-banks, instead of selling derivatives, wound up selling put contracts for derivatives. This was a good deal for the money managers, who wound up with heads I win, tails you lose investments. But the guarantor-banks got lost on the way to Lake Wobegon.

Derivatives contracts can serve bona fide and valuable purposes when used in ways for which they were intended. But altering them so that they don’t really pass a lot of risk—transferring the upside, but not the downside isn’t much of a risk transfer—undermines the purpose of having a derivatives market. Suspicions arise that risk management got lost in the rush to record entries in that nice fee income category that would please stock market analysts and regulators. But risk, if unmanaged, remains coiled up, perhaps hard to see against the leaf cover on the forest floor, but ready to strike if the opportunity arises.

Derivatives have been taken too far. They’re not a magical instrument that will solve all problems in the financial markets. Like a socket wrench or a pair of pliers, they are tools, and nothing more. Like all tools, they must be used properly and wisely. Some shrinkage of the derivatives market, along with standardization of products and much greater transparency, would be a good thing.

Crime News: pet sitter that overfed potbellied pig charged with animal cruelty (no, we're not kidding). http://www.wtop.com/?nid=456&sid=1283269.