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The Real Reason the Big Boys Don't Want Credit Default Swaps to Be Regulated

George Washington's picture




 

Washington’s Blog.

Bloomberg has an article today quoting a couple of congress people acting as spokesmen for the 5 biggest banks:

Freshman
congressman McMahon told House Financial Services Committee Chairman
Frank he was worried that Obama’s derivatives plan, released in August,
would penalize a wide swath of U.S. corporations and could push jobs in
his home district overseas, McMahon said in an interview.

 

“It’s not just the farmers, and it’s not just the Wall Street guys,” said McMahon, a member of the New Democrat Coalition,
a group of 68 self-described pro-growth Democrats in the U.S. House of
Representatives. “It’s across the nation. American industry uses these
products for a very useful purpose, which keeps down prices and makes
consumer products cheaper.”

 

McMahon said Frank agreed
it was important to protect so- called end-users, the corporations that
rely on derivatives to hedge everyday operational risk, such as
fluctuations in foreign currency rates, interest rates and commodity
prices. The Obama plan would subject companies to higher collateral
requirements whether they trade standardized or customized contracts.
It also calls for most trades to be executed on an exchange or an
“alternative swap execution facility.”

Are McMahon and Frank right? Are derivatives necessary to keep prices down and make consumer products cheaper?

Well, initially, we are in a deflationary environment, largely caused by the use of massive numbers of credit default swaps (see this article by Newsweek; and even former SEC chairman Christopher Cox said:
"The virtually unregulated over-the-counter market in credit-default
swaps has played a significant role in the credit crisis'') . So I
guess, in that sense, the use of CDS has reduced consumer prices.

McMahon
and Frank are also lumping credit default swaps and other risky credit
derivatives in with derivatives pegged to currency, interest rates and
commodity prices. The above-described types of derivatives are apples
and oranges, and treating them as if they were the same is a recipe for
disaster. If these congressmen don't know the difference between
derivatives related to credit risks and derivatives related to
currency, interest rates and commodity prices, then they should not
even be let into the Congressional building for derivatives hearings,
let alone given a podium and a microphone.

As to CDS, leading derivatives trader and expert Satiyajit Das wrote a must-read article
pointing out the falsity of the justifications used by both buyers and
sellers of credit default swaps and other complex forms of "financial
innovation":

The unpalatable reality that very few,
self interested industry participants are prepared to admit is that
much of what passed for financial innovation was specifically designed
to conceal risk, obfuscate investors and reduce transparency. The
process was entirely deliberate. Efficiency and transparency are not
consistent with the high profit margins that are much sought after on
Wall Street. Financial products need to be opaque and priced
inefficiently to produce excessive profits or economic rents.

Das is not alone. The top derivatives experts all say
(except those who work for the too-big-to-fail banks) that CDS are
incredibly dangerous, don't provide much benefit to the consumer or the
economy as a whole, and must be reigned in.

The Bloomberg article goes on to give the real reason that the TBTFs and their many lapdogs in Congress don't want CDS regulated:

The change [in Obama's proposed regulation being championed by McMahon and Frank, which even the guy who formerly blocked regulation is now saying is too weak]
could protect billions of dollars in profit for the dealers. When
securities or derivatives are traded on exchanges -- where investors
can see real-time prices, rather than indicative prices sent by e-mail
in the over-the-counter market -- it can shrink the amount that dealers
make on each trade, known as the spread.

 

“Having
more discretion for the dealers in the regulations gives an extra
benefit to them by staying away from narrower spreads,” said Darrell
Duffie, a finance professor at Stanford University in California.

 

The
top five U.S. commercial banks, including JPMorgan, Goldman Sachs and
Bank of America Corp., were on track through the second quarter to earn
more than $35 billion this year trading unregulated derivative
contracts, according to a review of company filings with the Federal
Reserve and people familiar with the banks’ income sources.

 

The
banks are arguing that an exchange or trading-system mandate that
publicizes large trades could make it too expensive or impossible to
execute customer orders and hedge those trades at the same time,
according to the people familiar. Publicized large orders may dry up
the willingness of dealers and investors to buy or sell contracts, they
said...

Not mandating exchange or other types of electronic
trading “will probably prevent spreads from dropping like a rock,” said
Kevin McPartland, a senior analyst in New York at Tabb Group, a
financial-market research and advisory firm...

In
other words, beneath all of the fancy rhetoric from the TFTFs and
their mouthpieces in Congress, the real reason that they don't want CDS
regulated is because it will narrow the spreads, and they will make a little less money.
In addition, transparency would reduce the market, because investors
would see CDS as the snake oil that they are (outside of some very
narrow, specific uses).

The TBTFs couldn't care less that a huge, unregulated CDS market will destabilize the economy and lead to crises in the future.

Why should they? As Nobel prize-winning economist
George Akerlof predicted in 1993, the financial giants would use CDS
until the system crashed, knowing that the taxpayers would bail them
out when the crash happened.

They know the same thing will happen tomorrow . . .

The bottom line is that we are now in a system where gains are privatized and losses are socialized. The debate over CDS is really one part of the larger debate as to whether that system will continue or not.

 

 

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Sun, 10/11/2009 - 15:40 | 95968 Unscarred
Unscarred's picture

Thanks for citing the George Akerlof article.  I have no idea how well it was received by the financial and economic constituents of the day, but it should be getting a LOT more run now than it has.  Great stuff!

Sun, 10/11/2009 - 05:30 | 95746 Anonymous
Anonymous's picture

1. reform the SEC and allow ratings agency competition
2. restore Glass-Steagall
3. repeal most of the CFMA 2000

The modern day derivative and CDS should not be regulated, they should be banned outright as they were from 1907-2000.

Sat, 10/10/2009 - 20:44 | 95569 Anonymous
Anonymous's picture

Yeah, great article and great comments.

Sat, 10/10/2009 - 18:07 | 95477 Anonymous
Anonymous's picture

Here, HERE GW, that was a great article!

(Much better than the gold one you did, did you get my follow-ups about why currency risk trumps all, and that gold is the only real hedge against currency risk?)

Thanks, and again, GREAT article (THIS TIME)

V/R

Anon

Sat, 10/10/2009 - 18:03 | 95474 Anonymous
Anonymous's picture

Apocalypse Now- The idea of lower prices is a lie. Insurance and hedges increase the average price of goods, all it does is smooth out highs and lows - why are there insurance companies? Because they make money on the volatility driven by speculators that drive markets back and forth. The vehicles themselves make everything cost more and enable speculators to drive big movements in price - especially anyone with friends that own a printing press.

Sat, 10/10/2009 - 17:17 | 95454 Anonymous
Anonymous's picture

Apocalypse Now- The idea of lower prices is a lie. Insurance and hedges increase the average price of goods, all it does is smooth out highs and lows - why are there insurance companies? Because they make money on the volatility driven by speculators that drive markets back and forth. The vehicles themselves make everything cost more and enable speculators to drive big movements in price - especially anyone with friends that own a printing press.

Sat, 10/10/2009 - 00:53 | 95138 Anonymous
Anonymous's picture

silly me, I thought the real reason to evade trading these on an exchange was that having to post margin on 100 trillion of CDS was.....IMPOSSIBLE

Sat, 10/10/2009 - 10:20 | 95259 bonddude
bonddude's picture

Haven't you heard? The Government is putting up the 5% margin and indemnifying losses.

;-) I keed, I keed.

Sat, 10/10/2009 - 05:13 | 95198 Anonymous
Anonymous's picture

CDSs are just like other swaps. If left to themselves it would be fine. It was the consequence of using CDSs to overleverage themselves without adequately modeling counterparty risk that fucked everything.

Sat, 10/10/2009 - 00:26 | 95120 River Tam
River Tam's picture

Reduced transparency and concealed terms...like a life insurance policy..or a credit card interest rate disclosure...or Tyler talking about Dark pools and spreads...or a very pretty date.

Fri, 10/09/2009 - 20:48 | 94896 Anonymous
Anonymous's picture

Should the boyz in Harlem invite McMahon over for tennis and tea?

Fri, 10/09/2009 - 20:03 | 94801 Anonymous
Anonymous's picture

Congress is being briefed by a couple of intern nerds who send a memo, the lobbyist then edit for sound bites. The checks in the mail bud ...and the wheels are greased. Remember back when the nobel prize was highly esteemed.

Sat, 10/10/2009 - 15:19 | 95405 ToNYC
ToNYC's picture

Kissinger can play cards with Arafat in Nobel heaven while Mother Teresa and the Dalai Lama are off in the smiles.

Fri, 10/09/2009 - 19:49 | 94769 Anonymous
Anonymous's picture

Since freshman Congressman McMahon represents Staten Island, New York City, does he represent the Wall Street bankers?

Sat, 10/10/2009 - 15:17 | 95403 ToNYC
ToNYC's picture

Better than that, the Treasury Secretary! As Andrew Sorkin relates Tim G.'s mindset in his new book, 'TBTF':

<snip>

"Those ferries, freighted with office workers, gave him pause. This is what it was all about, he thought, the people who rise at dawn to go to their jobs, all of whom rely to some extent on the financial industry to help power the economy. Never mind the staggering numbers. Never mind the ruthless complexity of structured finance and derivatives, or the million-dollar bonuses of those who had made bad bets. This is what saving the financial industry is really about: protecting ordinary people with ordinary jobs."

<snip>

And so McMahon can be the shill for the great unwashed who were about to be shut down if TARP 1 payment didn't happen even though the mail was 300:1 against. HP dove over the goal line on that one. McMahon is experientially challenged to weigh in on any substantive basis, so like the perfect trainee, sells the company goods without the baggage of personal opinion. 

Meanwhile back in the Wild West to the North just a little, the rumors fly and the CDSs remain licenses in full effect to steal.

 


 


 

Fri, 10/09/2009 - 20:25 | 94848 Anonymous
Anonymous's picture

No he represents the legions of ex-wall street employees that have been run over by all of this "innovation".

Fri, 10/09/2009 - 18:42 | 94697 aus_punter
aus_punter's picture

Lumping CDS and Orange Juice futures shows into the same argument  1. How desperate these lobbyists, I mean congressman are and 2. How little understanding regulators have.  

Fri, 10/09/2009 - 18:38 | 94688 Miles Kendig
Miles Kendig's picture

That article from Satiyajit Das is one of the best written lately on the subject.  I would love to see Satiyajit Das & Chris Whalen hit the hill together.  The discussion of privatizing gains and socializing loses I believe was also addressed fairly well recently by Wilem Buiter and that article was listed as a daily read here at ZH.

http://blogs.ft.com/maverecon/2009/10/after-subverting-bank-insolvency-o...

Fri, 10/09/2009 - 18:18 | 94681 mannfm11
mannfm11's picture

It occurred to me that if GM had sold enough default swaps against itself, it could have paid off its debt.  There should be a law the next time these outfits are too big to fail, they go out of business and bugs bunny gets the bank.  The GS, UBS, RBS, AIG derivative deal reeks of fraud, like AIG was supposed to hold the bag.  The one company in AIG that created that mess should have been stripped out of the company and thrown in the street.  That would have regulated CDS's permanently to the garbage dump.

Fri, 10/09/2009 - 18:15 | 94678 Anonymous
Anonymous's picture

Washington rocks!

Fri, 10/09/2009 - 15:12 | 94379 Anonymous
Anonymous's picture

Argh this such a shit article...ppl still haven't explained clearly to me why fully collateralised vanilla cds pose more of a systemic risk than other derivatives.

Sat, 10/10/2009 - 18:47 | 95490 trader1
trader1's picture

the following is not only applicable to vanilla CDS....but, OTC derivs in general:

1) They have no regulation.

2) They have no standards.

3) Without standards there can be no viable market.

4) They are unlisted.

5) They are traded by private treaty negotiation.

6) They are valued by "mark to model," which is a total cartoon.

7) They have no financial guarantee such as a clearing house.

8) They are unfunded special performance contracts floating in cyberspace. All funds in OTC derivatives are taken out as spreads and commissions.

9) More than 50 percent of the earnings of major international investment banks come from granting in the private treaty negotiation of these instruments of mass financial destruction.

10) Financial performance of OTC derivatives depends on the financial capacity of the loser in the transaction.

11) Control has been loose in interest-sensitive OTC derivatives because of multiple dealings outside of the initiating two parties until no one knows who has what.

12) The replacement value of these instruments is in the multi-trillions of dollars.

13) The massive expansion of these instruments has come in interest-sensitive and debt-guarantee instruments. Those are the most vulnerable.

(source: Jim Sinclair)

Sun, 10/11/2009 - 08:38 | 95774 Anonymous
Anonymous's picture

CDS are also illegal gambling contracts despite a special law lobbied thru to supposedly make them legal.

Sat, 10/10/2009 - 00:31 | 95128 rifek
rifek's picture

1. Because the collateral was (and is) routinely misvalued.
2. Because even when the collateral is properly valued, the risk can't be determined. The CDS, although it is effectively an insurance policy, isn't held by the originating parties like an insurance policy. Instead, both parties trade their respective interests, exposing themselves and their buyers to default risks up and down the chain. And the chain is only as strong as its weakest link, whoever that may be.

Sat, 10/10/2009 - 05:10 | 95197 Anonymous
Anonymous's picture

Also, banks used CDS to tell their regulators that their loans had essentially no risk, because they had CDSs to cover in the event of default. So, the regulators let the banks continue to lend out or borrow even more money, which is how we got ridiculous leverage ratios.

What CDSs don't measure is counter-party default risk, and if that happens, then the entire system is fucked. This is the case with AIG, and why the government essentially funneled hundreds of billions through AIG into all the counterparties. If AIG failed, then the ripple effect would be humungous because all of a sudden these banks that had loans that were adequately covered with CDSs would all of a sudden be short, and consequentially fucked.

Sat, 10/10/2009 - 13:22 | 95324 Anonymous
Anonymous's picture

Color me simple...but, if the gov't can do whatever the hell they want in a "CRISIS"...why the hell can't the government declare the CDS contracts null and void?

Sat, 10/10/2009 - 08:49 | 95232 Anonymous
Anonymous's picture

ARGH

the cds's AIG wrote were bespoke contracts designed for regulatory arbitrage.....they were COMPLETELY different to the widely traded vanilla contracts.

Sat, 10/10/2009 - 06:53 | 95207 George the baby...
George the baby crusher's picture

Dito to that!

Sat, 10/10/2009 - 09:23 | 95243 bonddude
bonddude's picture

Any good bond trader know why they prefer bonds. Opacity in pricing. Although the prices must be reported it is up to 15 minutes later in Corps. and Munis. These little darlings are like the "old days" to a bond guy, virtually no price reporting. LOTS OF MARK UPS. Yeah, there are many kinds whatever. 

It's all leverage. If these guys (congress) are now seeing the argument that people are going to lose jobs because this leverage needs deflating then the jobs were not real to begin with.

Reminds me of the Sopranos.

Sat, 10/10/2009 - 09:21 | 95242 bonddude
bonddude's picture

Any good bond trader know why they prefer bonds. Opacity in pricing. Although the prices must be reported it is up to 15 minutes later in Corps. and Munis. These little darlings are like the "old days" to a bond guy, virtually no price reporting. LOTS OF MARK UPS. Yeah, there are many kinds whatever. 

It's all leverage. If these guys (congress) are now seeing the argument that people are going to lose jobs because this leverage needs deflating then the jobs were not real to begin with.

Reminds me of the Sopranos.

Fri, 10/09/2009 - 15:12 | 94378 Anonymous
Anonymous's picture

Argh this such a shit article...ppl still haven't explained clearly to me why fully collateralised vanilla cds pose more of a systemic risk than other derivatives.

Fri, 10/09/2009 - 14:52 | 94321 bugs_
bugs_'s picture

I wish we had one of them doomsday machines....I

mean "alternative swap execution facilities".

 

Fri, 10/09/2009 - 14:37 | 94287 E Thomas St.
E Thomas St.'s picture

The problem with McMahon's comparison is that CDS are not futures contracts.

Fri, 10/09/2009 - 16:34 | 94565 pivot
pivot's picture

i think they are more similar than you realize.

Sun, 10/11/2009 - 02:26 | 95715 Hephasteus
Hephasteus's picture

Ya. Since nobody buys credit default swaps for past financial events you can't call it anything BUT a futures market.

Fri, 10/09/2009 - 16:53 | 94588 Ducky
Ducky's picture

They are very different when it comes to clearing. If you buy a futures contract the seller is not your counterparty going forward.

This is why people that had CDS contracts with Lehman and Bear had default risk while people that had exchange traded futures that they bought or sold through them had none. The exchange is on the hook and the exchanges did just fine.

Exchange risk management is much beter than OTC risk management.

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