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.

Currency Market Ripoffs

News services report that banks have allegedly been ripping off customers in the foreign exchange markets. Major banks buying or selling foreign currencies for institutional investors have supposedly been cheery picking their day's transactions after the market closes, keeping the good trades for themselves, and sticking their customers with the lousy trades. Unlike the stock markets, there isn't a consolidated tape in the currency markets that reports transactions publicly, and customers are at a disadvantage in trying to figure out whether they've gotten fair prices. The banks have a free hand to turn lead into gold by keeping the golden trades for themselves and dumping the lead into customer accounts.

It's easy to be a winner in the financial markets if you have the benefit of hindsight and can help yourself to a do-over. It's even easier when you're transacting in an unregulated market that's largely opaque to your customers. The currency markets are unregulated, and only the naive and poorly read would be surprised by the recent allegations. After all, similar ripoffs occurred in the opaque mortgage-backed securities and derivatives markets, crucial parts of an unregulated shadow banking system whose collapse in 2007-08 continues to haunt our economy today. A recurring story of Wall Street is that insiders will rig the market against the public whenever they can. The news reports about currency trading ripoffs is just another iteration of that story.

That institutional customers, including some well-known money managers, were victimized brings to mind a lesson of the Bernie Madoff scandal: even the well-heeled and sophisticated are vulnerable. No one is safe when transparency and accountability are in short supply. Moreover, pension funds and other investment vehicles holding money for the benefit of middle class workers and investors are among the victims. This isn't just a problem for residents of Palm Beach.

Greater regulation of the currency markets, even simple measures like better recordkeeping of transactions and more timely confirmation of trades with customers, would enhance accountability. However, today's political climate precludes greater regulatory protections, even if pension funds and other repositories of middle-class assets are at risk. Some victims have filed lawsuits--the State of Virginia even intervened in one--and perhaps they'll recover their losses after a long slog through the courts. Otherwise, caveat emptor remains the word of the day.

Financial Regulatory Reform: the New, Smaller Derivatives Market

One consequence of the regulatory reforms that the Obama administration has proposed will be a smaller derivatives market than existed in the boom years before 2007. We have learned that the derivatives market is inextricably intertwined with the banking system. We've also learned that, instead of ameliorating risk, derivatives exacerbate risk and then concentrate it on a few firms or even one large financial institution (read AIG). After all that, Wall Street firms are still making plans to buy life insurance contracts and package them into asset backed securities. Risk wouldn't be spread out and softened. Instead, investors in the new contracts would simply be gambling on longevity, nothing more or less. Insurance companies and other financial companies wouldn't have their risks reduced; if anything, insurers' risks would grow as policies that historically would have been cancelled by customers no longer needing coverage are bought up and kept in force by investors in the new insurance-backed securities.

The proposals directly addressing derivatives call for the public trading and centralized settlement of standardized derivatives contracts, and increased recordkeeping and reporting for customized derivatives. These measures will help. But they are only some of the steps in the journey.

The final steps in reshaping the derivatives market will come from bank regulatory reform. This is because virtually all the risks in the derivatives market eventually connect back into the banking system one way or another. That's what we've learned with CDOs, CDOs squared and, especially, credit default swaps. The only parties that can play in the derivatives sandbox are the big banks and their counterparties. The big banks will almost always be connected somehow to standardized derivatives contracts (after all, they will capitalize the central clearing agency, and if it faces insolvency, they will have to ride to the rescue because they can't afford to let it go under). And the big banks are the only credible counterparties for customized derivatives. Investors wouldn't buy a customized derivative from anyone else, because anyone else wouldn't be too big to fail and might be unable to honor its obligations under the derivative contract.

Bank regulatory reform includes a couple of measures crucial to the future of the derivatives market. First, bank leverage ratios will be lower. Leverage was a key element to the explosion of the derivatives market in the early 2000s. So a contraction of leverage necessarily means a smaller derivatives market. Second, bank capital requirements will be strengthened and regulators will look askance at special purpose vehicles and other accounting slights of hand that purported, but failed, to shift the risk of loss from derivatives away from the banks. Thus, derivatives exposure will require banks to maintain higher levels of capital without having a convenient potted plant to dump them into. This will raise the cost of doing business in the derivatives market and act to limit the quantity of derivatives outstanding.

Thus, even though no federal regulator will attempt to dictate the quantity of derivatives contracts created or traded, the effect of federal regulatory reform will be to prevent them from reaching the gargantuan levels of yesteryear. This isn't bad. While proponents of derivatives argue that they promote growth, experience tells us that they also heighten the risk of financial crises, which have a notably negative effect on growth. A smaller, kinder, gentler derivatives market could help foster growth, but hopefully at a more sustainable level. We shouldn't fixate on what will produce growth next quarter or even next year. A long term perspective is needed now.

The Risks of Business As Usual in Banking

Banking today is structurally different from, say, three years ago. There are no more large brokerage firms under SEC regulation. All the major financial institutions are banks regulated by the federal banking authorities. There are notably fewer big financial institutions. Many faces in executive suites have changed.

But operationally, it would seem that plus ca change, plus c'est la meme chose. The banks still make big profits and pay big employee bonuses. They also take big risks. Today's Wall Street Journal reported on p. A1 that "value at risk," a measure of the potential for trading losses, is for the largest banks greater than it was in 2008, 2007 and even the boom year of 2006. In other words, after all the Federal Reserve accommodations, federal bailouts, bonus controversies, Congressional hearings and bank failures, business as usual continues and the banks are, if anything, putting taxpayers at greater risk than ever before.

That's bad, since business as usual is how we got into the recent credit crunch and Great Recession. Why haven't things changed? A couple of likely explanations suggest themselves. First, bank regulatory reform hasn't happened, and seems to be slipping toward the back burner. Health insurance reform is an extremely important priority, and, after eight years of meandering, the war in Afghanistan needs definitive direction. But let's remember that the current Great Recession was brought on by risky banking practices and more than anything the electorate chose Barack Obama as President to straighten out the economic mess. His administration cannot afford to lose focus of the need for financial regulatory reform. In the absence of reform, what else can we expect other than bad old business as usual?

The second likely explanation for the return and elevation of the banking system's risks is that the Fed, once again, is pumping out cheap credit. This time, it's really cheap credit, virtually free. Recall how banks make money. They borrow it (from depositors, commercial lenders, and nowadays most prominently the Federal Reserve) and lend it out or invest it. When the cost of borrowing is low, comparatively high risks seem sensible. (This is why so many people paid ridiculously high prices for houses when they could get 100% financing with interest only or option ARM loans--the credit was incredibly cheap so what did the price of the house matter?) High cost of funds imposes risk management discipline. Cheap money encourages profligacy.

How many times in the last decade or so have we seen this from the Fed? We've had the tech stock bubble, the housing bubble, the credit bubble, the 2008 petroleum bubble and now today's stock market, gold and who knows what else bubble. The Fed has made clear that it's going to keep credit cheap for an extended period of time. So why wouldn't the big banks ratchet up risk? Their costs are under control, courtesy of the Fed. And they know the taxpayers guarantee all their liabilities 100 cents on the dollar. What's not to like about risk? It's a great way to boost employee bonuses, when all goes well.

But the new data about banks taking more risk than ever raises the specter of another big asset bubble. If we are working our way toward another bubble, we'd better hope that this one defies the laws of economics and never pops. Since the Fed is already maintaining a zero interest rate for banks that borrow from it, it can't pull the nation out of another economic bust by lowering interest rates. There's no such thing as negative interest, because bank depositors will simply withdraw their funds and put the stuff in mattresses (which would mean the collapse of the financial system). The current combination of no bank regulatory reform, the cheapest credit possible from the Fed for an extended time, and a resumption and expansion of business as usual among the big banks could be deadly. With nothing changing, what can we expect except apres cette fois, le deluge?

Financial Regulatory Reform: We Should Taketh From, As Well As Giveth To, the Fed?

The wide scope of the Obama administration's regulatory reform proposals has triggered an economic recovery for lobbyists, and their frenzied paid, professional bewailing and whining has obscured some basic issues. We already knew, without being told, that banks wouldn't like the idea of a financial consumer protection agency. It also comes as no surprise that Wall Street would like to limit as much as possible the intrusion of regulators into their high margin derivatives business, even though that business brought the economy down last year with its reckless pursuit of profits without regard to risk.

But one issue that deserves more attention is whether the Federal Reserve should have responsibility for safeguarding the economy against systemic risk. This is the biggest regulatory reform issue. The reason why the current economic downturn has proven so intractable is the failure of a major part of the banking system due to uncontrolled systemic risk. We're talking about the unregulated multi-trillion dollar asset securitization market underlying the real estate and credit bubbles that popped so painfully. Banking collapses presage painful economic contractions (see, e.g., the history of the Great Depression and the Panic of 1907 for further details). The securitization market operated with virtually no meaningful risk management, either from Wall Street or the government. That's why things spun out of control and its risks became hideously large.

The Fed seems to be the principal nominee to serve as the systemic risk czar. It, after all, has played the biggest role in combating the current downturn and has regulatory authority over all the major Wall Street banks anyway. But is the Fed the best choice?

The Fed's current regulatory responsibilities already fill its plate. It is required to serve as the central bank--the lender of last resort to the banking system. It also is supposed to manage the economy. Section 225a of Title 12 of the United States Code provides that "[t]he Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, the Fed is supposed aim for "maximum employment, stable prices, and moderate long term-interest rates."

This is mandate makes the Fed a regulatory pushmi-pullyu. When the Fed is confronted by a slowing economy, it is supposed to lower interest rates to promote growth and employment. But doing so can run the risk of price inflation and asset bubbles. In the 1970s, the Fed chose to favor growth and employment, instead of raising interest rates to control inflation. The result was price inflation and little growth (the now infamous stagflation). In the late 1990s, the Fed lowered interest rates to promote growth, facilitating the expansion of the money supply that fueled the tech stock bubble. Then, in the aftermath of that bubble bursting, and the threat of recession from the 9-11-2001 terrorist bombings in New York and Washington, the Fed again lowered interest rates. This time, it fueled the real estate and credit bubbles that produced the train wreck we're now on. In other words, the Fed's legal mandate, as it has been interpreted for much of the past 40 years, appears to be inherently destabilizing.

If the Fed became the czar of systemic risk, things would only get murkier. In the world of commerce and economic enterprise, risk is a predicate to growth. Systemic risk is a predicate to systemic growth. Given its competing legal responsibilities, would the Fed be tempted to favor growth while allowing "some" systemic risk? Could the Fed, given its seemingly unlimited ability to print money, subsidize (at taxpayer risk and expense) Wall Street firms and others taking systemic risk in the hope of fostering more growth? The Fed's performance in the last 15 years reveals a tendency to underestimate systemic risk. People with a history of driving too fast usually have their licenses suspended or revoked. Why should we give a regulator that has a history of incautiousness the job of safeguarding the economy against systemic incautiousness?

The literary pushmi-pullyu exists only in fiction, and perhaps the regulatory pushmi-pullyu should no longer be a reality. Wouldn't it be better to relieve the Fed of the responsibility for promoting growth and employment? Shouldn't that responsibility rest in the hands of the elected government--the President and Congress? After all, fiscal policy, not monetary policy, fostered America's recovery from the Great Depression. The massive wartime spending that was required to fight World War II made America prosperous again. The federal government financed the war by sharply raising income taxes and borrowing record amounts of money. There were no Hail Mary pass-type policy measures by the Fed to print money in new and ever more creative ways.

The Fed's primary monetary policy tool--the level of interest rates--operates as a government price control. The government sets the price of short term credit. Doesn't the evidence now allow us to stipulate that such price controls have had the perverse impact that government price controls usually have? The government's underpricing of credit has produced repeated booms and busts in the asset markets during the last 15 years. We're now slogging through the worst recession since the 1930s as a consequence. Isn't it clear that government pricing of credit has produced distorted allocations of capital that may hamper long term economic growth? Cheap money goes into investments that produce the greatest short term returns. Higher interest rates induce more disciplined and thoughtful investing aimed at longer term gains. Don't we want more capital invested in ways that would produce the greatest long term returns--which tend to benefit workers and communities, as well as investors, instead of the privileged few that have profited from the short-mindedness of recent years? Have we just seen the latest manifestation of this perversity with the 60% jump in oil prices this year, in the face of a terrible recession? One wonders who, besides oil producers and perhaps Goldman Sachs, a noted commodities trader that just reported exceptional earnings, would have benefited from this latest asset bubble? Wouldn't systemic risk be fueled by lower interest rates? From a borrower's standpoint, as money becomes cheaper, higher risks become logical. If the Fed lowers short term interest rates marketwide, it may be increasing the levels of systemic risk. This, indeed, is likely an important reason for the astronomical size of the recent credit bubble.

Relieving the Fed of the responsibility to manage the economy would allow it to serve as the czar of systemic risk in a way consistent with its other legal responsibilities. After all, a central bank primarily focused on maintaining the health of the banking system would want to prevent high levels of systemic risk. It would no longer be tempted to compromise the safety and soundness of banks, and the moderation of systemic risk, in order to maximize employment and economic growth.

In Washington, it is axiomatic that government agencies do not readily give up power. After all, the more powerful you are, the more important you become. Minor bureaucrats are not invited to soirees in Georgetown. It would be unlikely that the Fed would give up its responsibility for the management of the economy without the mother of all bureaucratic battles. And Congress and the White House might not want to take it away because then they'd have the hot tamale in their laps.

So how do we avoid making the regulatory pushmi-pullyu even larger? Give the systemic risk job to the FDIC. Such a responsibility would be consistent with the FDIC's mandate to safeguard the banking system--no pushmi-pullyu problem there. And the FDIC is perhaps the only federal agency that has distinguished itself in the recent financial markets debacle, spotting problems earlier and proposing better solutions than more powerful players. Good performance and sensible ideas are rarely rewarded in Washington, a city where the well-connected and undeserving manipulate power to triumph over the meritorious. But perhaps once, just this once, we could make an exception.