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.

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.

A Proposal for Reform: No More Managed Money in the Synthetic Derivatives Market

Synthetic derivatives are having their 15 minutes of fame. It began with the SEC's lawsuit against Goldman Sachs, which featured the world's best known synthetic CDO, ABACUS 2007-AC1. Goldman allegedly structured this deal in a way that favored the short side investor, John Paulson & Co., without telling the long side investors about Paulson's involvment in choosing the collateral. Now, the financial press reports that Morgan Stanley is under SEC investigation for creating synthetic CDOs called "Baldwin" and "ABSpoke" in a way that supposedly favored the short side, and then itself investing in the short side. If the reports about Morgan Stanley are true, its conduct would arguably be worse than Goldman's, which did not include a proprietary bet against its long side customers. Other major Wall Street banks are also reportedly under investigation for structuring similar transactions and then taking the short side.

Enough already. Synthetic CDOs are pure bets, like sports bets. Unlike "real" CDOs, which can be connected to substantive economic activity, synthetic CDOs have no socially redeeming value. Yet, they can cause billions of dollars of losses. One solution would be to ban them outright. However, investors might simply go to offshore markets, where transactions would be even less visible and regulated than they are now.

A better idea would be to protect the money we really care about: managed money. Institutions holding or investing money for others shouldn't be allowed to transact or invest in synthetic CDOs or other synthetic derivatives. That would include broker-dealers, mutual funds, pension funds, banks and credit unions, insurance companies, investment advisers, trust companies and other fiduciaries, financial advisers who manage funds for clients, and anyone else who holds or invests money for others. The prohibition would not only apply to direct transactions and investments in synthetic derivatives, but also indirect transactions and investments through parent corporations, subsidiaries or other affiliates or agents. We wouldn't allow money managers to book or invest in sports bets. Why let them bet or make book in synthetic derivatives, which are analytically indistinguishable from sports bets? One advantage of taking the managed money approach is that the prohibition would extend to offshore markets as well as the U.S. market.

An exception could be made for independent hedge funds and other independent entities that receive no government subsidies, bailouts, or benefits (like deposit insurance) and whose investors are limited to individuals meeting the definition of accredited investors (i.e., those with net worths of $1 million or more, or who make more than $200,000 a year ($300,000 for married couples)) and institutions that aren't themselves prohibited from transacting or investing in synthetic derivatives (remember, no indirect transacting or investing). That would amount to a rather small universe of gamblers, but the point is to protect managed money.

Of course, Wall Street would howl in protest over such a proposal, as the lost profits could seriously impact bonuses. Tant pis, as the French would put it. Whatever Goldman Sachs and other big banks might say about their conduct not being illegal, none of them have made a coherent case why synthetic derivatives are good or socially beneficial. Only the most money-obsessed parents would want their children to grow up to sell synthetic derivatives. Plenty of derivatives contracts have made the trek to Boot Hill (such as the once popular portfolio insurance). The synthetic derivative has had plenty of opportunity to demonstrate its value to society, and has failed abysmally. R.I.P.

The Fallacy of High Falutin' Finance as Policy

By now, it should be clear that the advanced nations of the West have financed their way into a tar pit. Government policies to spur economic growth have devolved into ever more elaborate ways for citizens and governments to borrow, not to invest but to spend. The result has been recession, stagnation, volatility, heightened unemployment, smaller 401(k)s, underwater homeowners, and lowered expectations.

America's prosperity in the early 2000s came from real estate and credit bubbles fueled by Federal Reserve easy money policies and a large array of federal subsidies. The federal government's conscious decision in the 1990s not to regulate derivatives gave Wall Street's financial alchemists free rein to contort the financial system into a labyrinth of interconnections and pure side bets that remains impenetrable, harboring untold Minotaurs. When things blew up, the government's "solution" was to engage in more financial manipulation, bailing out the big banks that caused the problem with subsidies financed by deficit spending and a deluge of printed money courtesy of the Fed. Vast amounts of bad private sector debt was, in effect, transferred to the federal balance sheet, where it will burden future generations and hinder economic growth.

Things in Europe are even loopier. Most of Europe formed a currency union without effective control over the "union's" finances. The original idea was that by adopting a bloc-wide currency, trade barriers and transactions costs associated with currency conversions and fluctuations would be lowered and economic efficiencies would be achieved, facilitating growth. But the concept would work only if everyone stayed on the same prudent fiscal page. The absence of effective controls created incentives to cheat. An easy way for a member nation to slip a few extra shrimp on the barbie for itself was to borrow more than the rules allowed, perhaps with a sleight of hand or two arranged by Wall Street to maintain the appearance, if not fact, of propriety. The prudent, productive nations--especially Germany--profited from selling their products to debt-fueled southerly neighbors. But they want no part of the costs of their prosperity.

The Euro is really the Deutsche Mark, by another name. Germany was for a long time the strongest proponent of the Euro bloc, hoping that it would bring continent-wide prosperity and ready markets for German goods. Success, however, would have required that everyone on the continent become German, de facto if not de jure. Some other Euro bloc members apparently viewed the Euro bloc as a way to opt into a strong, stable currency, which would attract capital and lower their borrowing costs. But what happens when you lower borrowing costs? The same thing that happens when you lower the price of anything--people consume more of it. So people and governments borrowed more. The less thrifty Euro bloc members engaged in a financial manipulation, too, just differently and with the results we see today.

So the advanced Western nations have delved into financial machinations, shuffled some documents around, and appeared magically to foster economic growth. Forgotten, apparently, was the axiom that there is no such thing as a free lunch. Easing up on home loan standards, pushing up real estate prices, dumping borrowed money into consumers' hands through mortgage refis and home equity loans, ultimately don't create the conditions for economic renewal. An economy can't be built around borrowing and consumption. It has to be based on production. The wealth of nations comes from taking the resources of the Earth and converting them into forms usable by humans. That was so when hunter gatherers prospected for flint to swap for furs, and it's true today.

Even in Asia, where folks haven't forgotten that productive capability is what counts, the largest economy, China's, rests at the edge of the precipice. By linking the yuan to the dollar to get a trade advantage, China effectively vested its monetary policy in the U.S. Federal Reserve. That agency has famously kept short term rates extraordinarily low and will do so "for an extended period of time." The asset bubbles and price inflation that remain muted, for now, in America are emerging in China. China's central bank has raised bank reserve requirements, three times now this year, in an effort to keep the lid on the pot. To combat its own financial manipulation, China is slowing its economy down, and in so doing slow the world economy's recovery from recession.

When and how will this end? Only time will tell. There's too much debt, much of it cleverly stashed away in shifty derivatives transactions, for anyone to really know what's going on. The Euro bloc situation may give us some clues. Just two days after EU leaders trumpeted a much larger than originally expected bailout for Greece, European markets are sliding in the belief that yet bigger bailouts--for Portugal, Spain and who knows who else--will be necessary. It's doubtful that Europe (read, Germany), looking at a bill of hundreds of billions of Euros, has the wherewithal and stomach to organize a comprehensive Euro bloc bailout. And no one else can save Europe. The American financial crisis was just barely contained by the federal government. There's nothing America, beset by Tea Parties, can do for Europe. The 2007-09 recession in the West was stabilized by transferring bad private debts to governments. Where, then, can bad government debts be transferred? Abstractly speaking, to the strong governments with good credit ratings. But there's a political factor--the latter have to be willing to accept the transfer, and economic rationality rarely enters into political discourse. So the outcome is very much in doubt.

From some perspectives, much and perhaps most of the industrialized West is insolvent. The parts that aren't will probably bolt for high ground. There are many good reasons to institute serious, substantive regulation of the derivatives markets. An overpowering one is these contracts have created the illusion that we can use financial machinations to create prosperity. That's an illusion that must be destroyed.

Does Too Big to Fail Mean Too Big to Change?

Now that we, the taxpaying electorate, have bailed out Wall Street, Wall Street is mightily resisting all efforts toward effective financial regulatory change. The proposed independent consumer protection agency seems likely to end up a division of the Fed. That would be the same Fed that famously insisted there was no housing bubble--right at the peak of the housing bubble. If they can't see the problem, they won't fix it. Consumers, emptor.

Investors, emptor, as well. It now seems that the concept of a fiduciary duty probably will not be imposed on stockbrokers. Too bad, since it would have required stockbrokers to put the customer first--admittedly a quaint notion but one that might restore some confidence in the financial markets. But given how the Treasury Department and the Fed have persistently put Wall Street first, with taxpayers and everyone else second, it's hardly surprising that Congress and the administration don't see why investors, who crucially furnish the capital that fuel the financial markets, should get a break.

The derivatives market--the shadow banking sector whose unregulated rambunctiousness made the mortgage and credit crises of 2007-08 possible--continues to dodge and weave away from serious efforts at reform. While the CFTC and SEC are pushing for change, one gets the sense that power brokers are quietly maneuvering at Congressional fundraisers to put concrete shoes on derivatives reform and take it for a nocturnal boat ride.

The "Volcker Rule," a proposal to separate taxpayer supported federally insured deposits from high risk bank proprietary activities, seems to have run afoul of a basic Wall Street principle: money talks and fairness walks. The financial sector, once the epitome of free markets, now seems never to see a federal subsidy it doesn't like. Moral hazard is good for profits, and profits are good for bonuses. Wall Street will pig out on as much federal largess as it can scoop out of the hands of taxpayers.

All this isn't surprising when one considers that the basic structure of Wall Street was saved in the bailouts of the last 18 months. The big banks now follow the imperative of all organizations and endeavor to preserve their status quo. Given their enormous financial power, restored by dumping a lot of risk and loss onto the backs of taxpayers, it's hardly surprising they can wheel in panzer divisions of lobbyists and roll back their opposition.

Too big to fail, therefore, may turn out to mean too big to change. The financial behemoths that played crucial roles in the recent financial crisis may escape largely unscathed and unchanged. What, then, would prevent a recurrence of the crisis? The tale of Fannie Mae and Freddie Mac may be instructive. For decades, Fannie and Freddie used their enormous financial resources to fund the most powerful lobby in Washington, bar none, while their officers and other personnel relentlessly made self-interested campaign contributions. Key members of Congress of both parties became running dogs for Fan and Fred, snapping up all the doggie treats tossed in their direction. All efforts to reform Fan and Fred, and reduce the systemic risk they presented, failed miserably. It was not until they, along with others, created a bad mortgage loan tsunami that overwhelmed every sea wall in the financial sector that the government, facing economic Armageddon, seized control of Fan and Fred, and put an end to their lobbying juggernaut. But the cost of nationalizing them has been hundreds of billions--a premium price for regulatory reform.

Not changing the landscape of financial regulation won't improve things, not in the short or long run. It would only set the stage for another crisis, one that very possibly will be worse than the recent one. The doctrine of too big to fail seems to have saved and consolidated powerful banks that now are using their restored financial and political muscle to hinder and delay desperately needed regulatory reform. Although the key players--Ben Bernanke, Henry Paulson and Timothy Geithner--surely wouldn't have intended such a result, their very strongly held belief that one must save the financial sector above all appears to have led to this dilemma. There is no shame or gratitude on Wall Street, where money--and only money--talks. If taxpayers bail them out, they'll proceed with business as usual, even when, and especially if, increased regulation to protect taxpayers would crimp their profits. Chumps are not meant to be repaid.

Federalism in the Derivatives Market

Financial regulatory reform at the federal level is bogged down in a lobbying scrum. The Senate Finance Committee just voted along party lines to send Senator Christopher Dodd's bill to the Senate floor. But the outcome and timing there remains in unclear. All we know is that something might happen sometime. The subject with the least certainty of reform is the derivatives market.

The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."

The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.

Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.

Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.

Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.

Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.

Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.

Will the Europeans Take the Lead on Reforming Derivatives Regulation?

On Leave It to Beaver, when Beav did something to dig himself deep into a hole, his brother Wally would say, "You've really done it now." The big banks on Wall Street may have really done it now in the derivatives market.

News media today report that Goldman Sachs and other Wall Street firms have been buying credit default swaps that would rise in value if Greece were to default on its sovereign debt. This follows other recent reports that Goldman Sachs helped Greece disguise the level of its indebtedness by offering derivatives transactions that wouldn't appear to be debt. Thus, Goldman helped Greece appear more fiscally sober than it was. Moreover, other European nations seem to have drunk of this same derivatives cup to sweep national debts under the carpet.

It would be difficult for an EU member to scold Greece for profligacy if it had indulged in similar extravagance. The Wall Street firms involved in these deals have the EU nations exactly where they want them--financially bound to the Street while mutually lacking the moral standing to police each other.

But then, it seems that Goldman (and other firms) may have also bet on a Greek default, after having aided its fiscal excess. If so, they would have gained perhaps hundreds of millions in fees for their derivatives products and then who knows how much profit if Greece collapses under a heavy debt burden that Wall Street facilitated. To make things worse, credit default swaps are sometimes thought to affect the market for the primary debt to which they relate, with increased credit default swap trading activity and rising prices fostering greater doubt about the debtor's chances. Thus, buyers in the credit default market might exacerbate the debtor's problems and thereby increase the profit potential of their credit default swaps.

If it's true that Goldman and other major Wall Street firms have been on both sides of the table with Greece (for them and then against them), they would have been too clever by half. Continental Europeans almost reflexively mistrust "Anglo-Saxon capitalism." They have limited faith in market forces, and are quite willing to accept the stability of government control over market volatility. Business people are not as highly regarded in the EU as they are in the U.S., and don't have the political pull in Berlin and Paris that they do in Washington. Per capita income in Western Europe was, some 40 years ago, close to per capita income in America. Today, it's about thirty percent lower. The Europeans have been willing to pay the economic price for slower growth in exchange for greater stability. After the American-spawned mortgage crisis and credit crunch of 2007-08, they've lost a lot of faith in market forces. The sovereign debt mess would only reinforce these feelings.

There's a good chance that Europe will take the lead in reforming the regulation of derivatives. The EU already leads the U.S. on antitrust enforcement and electronic privacy. Big American companies like Microsoft and Intel have had to knuckle under to EU regulatory imperatives that reached beyond the requirements of U.S. law. Goldman Sachs, J.P. Morgan Chase and other denizens of Wall Street are not worshiped across the pond. Even worse, they've made various European governments appear to be easy marks. No one likes to be seen as a gullible dupe, especially not high ranking government officials who are the likely dupes. Regulatory fervor is undoubtedly rising east of the English Channel.

By all indications, neither Congress nor the Obama administration are focused on reforming the regulation of derivatives. Heavy duty lobbying by Wall Street is probably the most important reason for their inaction. But that will leave an open field for the Europeans to do as they please. Ninety percent of life is just showing up, as Woody Allen once said. American participation would help shape the future regulatory structure, and make it more closely resemble something we'd prefer. It's fallacious to think that the regulation of the derivatives markets won't change just because of somnolence on the Potomac. The world today is much bigger than the United States, and will move on with or without the United States.

Will Wall Street Get a Pass on Derivatives Reform?

Both Republicans and Democrats, in the rush to seize the momentum of today's neo-Populism, are buying up the entire denim overalls market and learning to chew straw. But they seem to have lost focus on the derivatives market, the place where the 2007-08 financial crisis began. Had it not been for the big Wall Street firms who created and underwrote vast quantities of mortgage-related derivatives, like CDOs, synthetic CDOs, CDOs squared, and other diverse and sundry bets and side bets on the values of all variety of assets, and their amen choir of money managers and investment advisers who drank avidly of some special lower Manhattan kool-aid before chanting that real estate values would never fall, we wouldn't be where we are today. The Great Recession was caused, first and foremost, by excess on Wall Street in the derivatives market. Profligate borrowing and overspending by consumers, and poor management by the U.S. auto companies and other corporations, were secondary problems that came into play only after the financial system froze up and required a multi-trillion dollar bailout from . . . well, you and me.

The most pressing problem in the derivatives markets is the lack of information. Investors don't know and can't easily learn what they've gotten themselves into. We can say that a thousand times, but let's recall the metaphor that a picture is worth a thousand words. There are very few pictures of the derivatives market, and they would only show a bunch of people in front of computer screens shouting into telephones. Tape recordings, however, fit the metaphor nicely. In financial dealings, what people say is much more important than how they look. As luck would have it, a few tapes of the goings on in the derivatives market have surfaced.

In December 1994, the SEC sued the securities broker-dealer subsidiary of a large bank called Bankers Trust. (In the Matter of BT Securities Corporation, SEC Rel. Nos. 33-7124, 34-35136 (Dec. 22, 1994)). As it happened, BT Securities taped recorded its derivatives sales people, a common practice on Wall Street as a protective measure against customers who try to avoid responsibility for their transactions. Of course, what's sauce for the goose can be sauce for the gander and for regulators, and the SEC got plenty of sauce from the BT Securities' tapes. As presented in the SEC's allegations (which BT Securities neither admitted nor denied), here are some of the tidbits found on the tapes.

BT Securities sold a company called Gibson Greetings (a greetings card company) customized derivatives called interest rate swaps that were meant to reduce Gibson Greetings' borrowing costs. These derivatives didn't trade in a market. Thus, there was no publicly quoted price for Gibson Greetings to compare BT's prices against. BT used computer modeling to determine the value of these derivatives. Gibson Greetings, which had to account for the derivatives on its financial statements, depended on information from BT to establish their values. Some of the derivatives were leveraged, with the result that small interest rate movements could produce large changes in value.

Gibson Greetings didn't fully understand the derivatives it bought--and BT knew it. A managing director at BT was taped saying, "from the very beginning, [Gibson] just, you know, really put themselves in our hands like 96% . . . And we have known that from day one." This managing director also said, "these guys [Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us." Thus, Gibson Greetings was at an informational disadvantage, and BT understood that was good for BT.

Many of Gibson Greetings' derivatives positions were losers. Gibson Greetings looked to BT for information about how much it was losing. BT apparently wasn't eager to give its customer bad news and understated the losses by millions of dollars. This lack of candor created a "differential" between Gibson Greetings' actual losses and the rosier picture it received from BT. The informational "differential" only exacerbated the problem. If BT had to unwind the positions, Gibson Greetings would be in for an unpleasant surprise. As a BT managing director put it," . . . the problem is that we are too far away between what he [a Gibson Greetings executive] thinks it is and what reality is . . . You know, we gotta try to close that gap." The managing director suggested more lies to offset the effect of the earlier lies: " . . . when there's a big move, you know, if the market backs up like this, and he is down another 1.3 million, we can tell him he is down another 2. And vice versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can say you have only made back a half a million."

A number of the derivatives BT sold to Gibson Greetings were supposed to reduce or offset negative effects of earlier derivatives Gibson Greetings had bought from BT. But, according to the SEC, BT did not disclose to Gibson Greetings that the terms of the new derivatives sometimes included unrealized losses or fees, totaling millions in the aggregate, that would make the transactions less beneficial to BT.

The SEC wasn't alone in getting BT tapes. In litigation brought by another BT client, consumer products giant Proctor & Gamble, more taped recorded statements were made public. In one conversation, two BT employees discussing a derivatives transaction with P&G allegedly said, "They [P&G] would never know. They would never be able to know how much money was taken out of that [in reference to large expected BT profits from the transaction]." The other employee allegedly replied, "Never, no way, no way. That's the beauty of Bankers Trust." See http://www.businessweek.com/1995/42/b34461.htm. Another BT employee allegedly said about derivatives, "Funny business, you know? Lure people into that calm and then just totally f___ 'em."

The picture drawn by these tapes is that even large, successful business corporations have a hard time understanding complex financial instruments created by Wall Street and sold in an opaque environment. It's ironic that Wall Street apparently has recruited a number of its corporate clients to lobby against reform of the derivatives markets. If it's accurate that they don't fully understand what these financial products involve, there's a possibility they've been maneuvered by the potential predators into lobbying against regulatory reforms that could reduce the ability of the predators to victimize them. But if you don't know what you don't know, you might do yourself unknowing harm, especially if you lobby against rules to make you more knowledgeable.

There are no great or complex secrets about the basic problems in the derivatives markets. Information from these tapes showing the derivatives markets as it really operates, warts and all, has been publicly available for 15 or more years. We can see that the derivatives dealers are able to take advantage of even large, successful businesses because of the opacity of the market. Investors can't protect themselves because they don't have the necessary information; and in some cases may not even realize that they don't have the necessary information. A century after Louis Brandeis' famous observation, sunshine remains a superb disinfectant. Here are some of our suggestions for improvement, made over two years ago but still pertinent: http://blogger.uncleleosden.com/2007/12/weve-got-bailouts-how-about-fixing.html.

How the Government Fosters Market Instability

The U.S. government promotes instability in the financial markets. Not intentionally; but its policies have that effect. Here’s how.

Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.

Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.

The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.

Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.

Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.

Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.

The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.

The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.

The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.

In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.

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