Have Derivatives Nailed Us Again?

As the stock market has plunged in recent weeks, banks stocks have often led the way into the abyss. This, in part, is because we don't know enough about the major banks.

Lack of information casts doubt on the value of a stock. Pigs in a poke sell for less than pigs out in the open. Banks, as we know from centuries of financial panics and runs, are volatile institutions that can seem healthy one day and on the verge of collapse the next. A bank's standing depends not only on its operational performance and financial condition, but also its public image. Gossip, whispers and rumors all can affect its image, and therefore its stability. Lack of information can inflame the impact of fast-moving negative news.

Europe's banks hold large quantities of troubled EU sovereign debt. The amounts are not entirely clear, but are hefty--hundreds of billions and maybe even trillions of Euros worth of dodgy debt. American banks are linked to European banks, among other ways through the settlement and clearance process for negotiable instruments, interbank loans, securities transactions, and derivatives deals. The first three exposures are pretty easily quantified. The last is not. Since most derivatives transactions are still direct, over-the-counter deals, there is no centralized venue for collecting information about many of them. No one knows if counterparty risk is concentrated in one or a few firms (a la AIG, circa 2008). No one knows if nonstandard transactions have created atypical risk profiles.

Banks often assert that they hedge their derivatives exposures. But there is no easy way to verify that. Hedges can be collateralized in whole, in part, or not at all. They can depend on creditworthy counterparties or hinky ones. They may be perfect, mirror-image hedges, or they might be approximations that don't fit any better than a used cheap suit bought in a thrift store. The Long Term Capital Management mess of 1997 resulted in part from "hedges" that turned out to be ill-fitting cheap suits.

The lack of information means that we can't tell how bad the derivatives exposures of big banks are. And that means we don't know what their stocks are worth. Hence bank stocks nose dive in times of doubt.

The Dodd-Frank legislation was supposed to cast sunlight on the derivatives market. Financial regulators are, as far as can be discerned, proceeding with perhaps some deliberate speed. The securities industry has wheeled out shiploads of lobbyists to to impede progress. Profit margins, like mushrooms, thrive in darkness. So the industry welcomes transparency as much as the Lakota welcomed Custer.

For all we know, the ghost of AIG-2008 lurks and derivatives might have done us in again. Remember that derivatives transfer risk, and an American bank doing a derivatives deal with a European bank or other firm may take on European risks as a result. Comparable risk transfer can occur if an American bank does a derivatives deal with an Asian bank that offsets its exposure by doing a mirror-image deal with a European bank. In such ways, derivatives can expand an American bank's risk profile well beyond its normal depositary and lending activities. Thus, derivatives can exacerbate the problem of too big to fail. But there's no ready way to tackle this problem, because information is lacking.

Europe's financial ministers today stopped another market rout with some talk therapy, leaking the word that they are vigorously studying the possibility of boosting the capitalization of Europe's banks. But they didn't say they had any concrete plans or proposals, just that everyone should feel good because they are concerned. The market bounced back, betting on positive rumors and gossip. But recent experience shows that bouncing balls readily fall back after going up, and the market will fall back again without something more concrete that inspires confidence. Given the darkness in the derivatives market, building confidence will be more easily said than done.

Lessons from AIG for Derivatives Clearing Houses

AIG's struggles to sell its $9 billion stock offering as a first step toward becoming a privately held company again remind us why the rather obscure lobbying battle over derivatives clearing houses is so important. AIG was Grand Central Station for high risk mortgage-related derivatives exposure at the time it was nationalized in 2008 in order to prevent its collapse and, with it, the collapse of the international financial system. Major banks that wanted to offload crappy tranches from mortgage-related CDOs and the like managed to persuade AIG to take a firm grip on the bag. When the mortgage market swooned, AIG was left holding the bag.

Almost no one, if one is generous with the benefit of the doubt, outside AIG--and perhaps even inside AIG--appeared to have realized until too late that the fate of the world's financial system and the world economy rested in the hands of an AIG subsidiary, AIG Financial Products Inc. This blog would become unduly lengthy if we detailed how incomprehensibly stupid shockingly large numbers of prominent people--inside AIG, among its counterparties, at its regulators, in Washington, and elsewhere--were in letting this situation come about. But one key consideration is that they didn't know in real time what was going on.

Much of the value of derivatives clearing houses is that they would collect information. With such information in hand, one could, comparatively quickly and easily, figure out where things might hit the fan. Although the question when things might hit the fan could depend on less predictable factors (such as the direction of the financial markets), we need to know if risk is again concentrated onto a single flimsy foundation capable of blowing up the world. Without clearing houses, that determination is exceptionally convoluted and time consuming. Examiners from the banking agencies, the SEC, the CFTC and myriad foreign regulators would have to fan out among numerous large financial institutions, each with a computer system that may well be incompatible with the computer systems of other major financial systems, and try to piece together where among untold numbers of attenuated or overlapping or circular derivatives transactions the hot potatoes have landed. The answer may well, as with AIG in 2008, come too late, from counterparties urging that taxpayers be dunned for yet another Wall Street bailout.

In the late 1960s, the stock markets had a record keeping crisis (the so-called "back office crisis"), where archaic paper-based systems couldn't provide the quality of settlement and clearance required for rising volumes of stock trading. Reputable brokerage firms collapsed or had to be merged with stronger firms, because their records were too messy to establish their financial viability. The SEC instituted a much more comprehensive regimen of improved settlement and clearance, record keeping, capital adequacy and examinations. Since that time, no large brokerage firm has collapsed or been forced into a shotgun merger because of back office problems.

Derivatives clearing houses could offer similar improvement to the markets. Detractors argue that they may present systemic risk themselves, by centralizing risk. But that is misleading. Because clearing houses would provide easily accessible information about the levels of risk they hold, either they and/or regulators can increase margin requirements (and required capital contributions from clearing house members) to provide a buffer against the centralized risk. That, in turn, would deter the taking of risks. While free market theorists (and bank executives at institutions that profit handsomely from their derivatives trading desks) shrink with horror at the notion of deterring risk, it was precisely the creation of too many mortgage-related derivatives, involving the origination of myriad exceptionally moronic no doc, no income, no asset, and no ability to repay loans, that fueled the inferno at AIG-FP. There is such a thing as too much risk, and we experienced it just a few years ago. Clearing houses would put a major barrier in the way of another such debacle.

Although hard core Soviets would blush at the way Wall Street today is revising history to blot out any mention of the 2008 derivatives catastrophe, we would invite history to repeat itself if we leave ourselves in ignorance again.