Why We Need Derivatives Regulation

[scandal 951]

http://dealbook.blogs.nytimes.com/2009/10/...gue-lynn-stout/

Why We Need Derivatives Regulation

October 7, 2009 , 4:30 pm

DealBook Dialogue

Lynn A. Stout is the Paul Hastings professor of corporate and securities law at the University of California, Los Angeles, Law School.

What caused the 2008 credit crisis? Loose monetary policy surely played a part. So did compensation plans that encouraged executives to take huge risks in the quest for short-term profits. But one fundamental cause of the credit collapse remains largely unrecognized and largely unaddressed: Congress’s decision in 2000 to legalize over-the-counter derivatives trading.

O.T.C. trading in credit default swap derivatives, or C.D.S.’s, brought our banking system to its knees.

The crisis began when the insurance giant American International Group disclosed that it had suffered huge losses trading C.D.S.’s, derivative bets that companies or municipalities would default on their bond obligations. Because A.I.G. was part of an enormous and poorly understood web of derivative bets and counterbets among the world’s largest banks and investment funds, many of these institutions feared that if A.I.G. went bankrupt, they would too. Only a $180 billion government bailout kept the system from imploding.

We could have avoided this if we had stuck with traditional derivatives regulation.

Wait a minute, some might say. “Traditional” derivatives regulation? Aren’t derivatives new, innovative financial products that have never been traded before?

No. Derivatives have been around for millennia. (The Babylonians used derivatives to bet on trading caravans). Although Wall Street traders and finance professors like to surround derivatives with confusing jargon and mathematical equations, behind the smoke lurks a simple reality: a “derivative” is only an agreement to pay or receive an amount of money determined by future changes in some interest rate, asset price, currency exchange rate or credit rating.

In other words, derivatives are bets — nothing more. Just as you can gamble on which horse will win a race and call your betting ticket your “derivative contract,” you can gamble on whether interest rates will rise by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract.

Bets can be used to hedge risks. A homeowner, for example, hedges by purchasing fire insurance, essentially betting the insurance company the house will burn down. If the house burns, the homeowner “wins” the bet, offsetting the loss of the house. (Wall Street traders might call homeowner’s insurance “housing value swaps.”) Similarly, an investor who owns a bond and is worried the issuer might default can buy a C.D.S. and bet against the issuer’s creditworthiness. If the bond decreases in value, the C.D.S. increases.

But bets can also be used to speculate, and speculation creates risks where there were none before. This is especially true when speculators who make different predictions trade with each other. (One thinks interest rates are going up; the other thinks they’re going down.) When a speculator trades with another speculator, both take on new risks they weren’t exposed to before, just as gamblers take on new risks when they go to casinos.

This is why healthy economies generally regulate gambling, especially large-scale derivatives gambling. For at least the last two centuries, the United States regulated derivatives using a two-prong approach. Speculative trading was allowed on organized exchanges like the Chicago Mercantile Exchange and the New York Stock Exchange, where trading could be overseen first by private governing bodies and later by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Outside the exchanges, O.T.C. derivatives speculation was discouraged by a common law rule called the “rule against difference contracts.” (“Difference contract” is the 19th century term for derivative.)

The rule against difference contracts, along with a sister doctrine in insurance law called the “insurable interest” requirement, treated O.T.C. derivative contracts as enforceable only if one party was using the contract to hedge a real, pre-existing risk. For example, you couldn’t collect insurance on a house you didn’t own or hold a mortgage on. Similarly, you couldn’t enforce a C.D.S. contract unless one of the parties to the contract owned or had a direct economic interest in the underlying bond on which the C.D.S. was written. “Naked” C.D.S.’s of the type that brought down A.I.G. were unenforceable.

The result was to keep derivatives speculation in check and largely confined to organized exchanges. At least, speculation was kept in check until the rules were dismantled. The dismantling began in 1986, when Britain “modernized” its laws by making all financial derivatives, whether used for hedging or pure speculation, legally enforceable. American regulators followed suit in the 1990s by legalizing O.T.C. trading for particular types of financial derivatives, especially interest rate swaps. This promptly led to the swaps-fueled bankruptcies of Orange County, Calif. (1994), Barings Bank (1995), and the Long-Term Capital Management hedge fund (1999). Despite these object lessons, Congress embraced wholesale legalization of O.T.C. derivatives in 2000 with the Commodities Futures Modernization Act.

That act declared O.T.C. derivatives exempt from C.F.T.C. or S.E.C. oversight. But it also declared even purely speculative O.T.C. derivatives contracts legally enforceable. The Commodities Futures Modernization Act thus eliminated, in one move, legal hurdles to derivatives speculation that dated back, not just decades, but centuries. It was this change in the law — not some flash of genius on Wall Street — that created today’s huge derivatives market. According to the Bank for International Settlements, by 2008 the notional value of the derivatives market had climbed to $600 trillion, amounting to nearly $100,000 in derivative bets for every man, woman and child on the planet.

This “modernization” has added enormous risk to our economy, making it possible for institutions like A.I.G., Orange County, Barings and Long-Term Capital Management (not to mention Enron, Bear Stearns and Lehman Brothers) to lose very large amounts of money very unexpectedly.

Of course, derivatives speculation in theory may provide social benefits that offset the social costs of systemic risk. Economists, for example, often claim speculators add liquidity to markets, and improve the accuracy of market prices. Yet there is virtually no evidence that legalizing speculative O.T.C. derivatives trading has provided significant benefits to the overall economy (although it clearly has provided benefits to Goldman Sachs and other winning derivatives traders). Meanwhile, taxpayers have spent nearly $180 billion on the A.I.G. bailout alone.

What to do? One possibility is to simply go back to what worked before. Lawmakers have started to move in this direction. The Treasury, for example, has proposed requiring “standardized” derivatives be traded on regulated exchanges, allowing only “customized” derivatives to be traded on the O.T.C. market. Unfortunately, the “customized” loophole is large enough for Wall Street to drive not just one, but several, trucks through.

An alternative might be to learn from history and the common law. By refusing to enforce off-exchange derivatives that didn’t serve a true hedging purpose, the old rule against difference contracts preserved the economic benefits of hedging transactions while discouraging the sort of large-scale, unrestrained derivatives speculation we have now learned, the hard way, can add intolerable risk to the financial system. And it did this without spending taxpayer money. During the 1990s boom, when O.T.C. derivatives were widely applauded as new financial “products” and “innovations,” this traditional approach had little appeal. It might have more now.

[one...two...tree 2,762]

[scandal 951]

Thanks for the vote Steve

I generally agree with much of what she says. Not everything though.

I'm all in favor of doing as much derivative trading as possible on-exchanges, with central clearing, as she espouses too.

Regarding the custom contracts that can't be exchange traded, she is advocating a return to distinguishing between hedging vs. speculating in OTC markets. I don't think that's practical or advisable. In our high speed electronic trading world, and with global markets extending 24X7 throughout Asia Europe and North America, it's just infeasible. The genie is out of the bottle, and we had better find a way to limit the risk of the OTC markets rather than pretending we can restrict them to "legitimate" hedges. One man's hedger is another man's speculator... to paraphrase the old line about terrorists and freedom fighters....

[mawilson 2,133]

This is total BS.

If a bank wants to take huge risks for short-term profits, it's their right to do so in a capitalist system.

Just don't go bailing them out when their trades blow up.

There's no such thing as a "systemic collapse". If Citi, JP Morgan Chase, Bank of America and the

rest of the crooks had gone bankrupt, more responsible investors would have come along and

bought up their assets on the cheap. That's what capitalism is supposed to be about - risk and

reward (or failure).

But of course the Republican-Democrat corporate regime would never let their Wall Street buddies

go out of business.

[scandal 951]

This is total BS.

If a bank wants to take huge risks for short-term profits, it's their right to do so in a capitalist system.

Just don't go bailing them out when their trades blow up.

There's no such thing as a "systemic collapse". If Citi, JP Morgan Chase, Bank of America and the

rest of the crooks had gone bankrupt, more responsible investors would have come along and

bought up their assets on the cheap. That's what capitalism is supposed to be about - risk and

reward (or failure).

But of course the Republican-Democrat corporate regime would never let their Wall Street buddies

go out of business.

You're a certified #######.

How would "responsible investors" buy anything at any price when the capital markets were literally on the verge of seizing up? If you can't access your funding account, just how do you buy something?

Money market funds that invested in the commercial paper market had "broken the buck".

"Responsible" businesses were unable to issue commercial paper to keep the normal wheels of business turning, or have you forgotten just how serious things really had become?

[one...two...tree 2,762]

Gramm-Leach-Bliley Act needs to be repealed.

Economists Robert Ekelund and Mark Thornton have also criticized the Act as contributing to the crisis. They state that while "in a world regulated by a gold standard, 100% reserve banking, and no FDIC deposit insurance" the Financial Services Modernization Act would have made "perfect sense" as a legitimate act of deregulation, under the present fiat monetary system it "amounts to corporate welfare for financial institutions and a moral hazard that will make taxpayers pay dearly".^[23]Nobel Prize-winning economist Paul Krugman has called Senator Phil Gramm "the father of the financial crisis" due to his sponsorship of the Act.^[24]Nobel Prize-winning economist Joseph Stiglitz has also argued that the Act helped to create the crisis.^[25] An article in The Nation has made the same argument.^[26]

Contrary to Phil Gramm's claim that "GLB didn't deregulate anything" (see Defense), the GLB Act that he co-authored explicitly exempted security-based swap agreements (a derivative financial product based on another security's value or performance) from regulation by the SEC Commission by amending the Securities Act of 1933, Section 2A, and similarly the Securities Exchange Act of 1934, Section 3A, to read, in part:^[27][28]

1. The definition of "security" in section 2(a)(1) does not include any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act [15 USCS § 78c note]).

2. The Commission is prohibited from registering, or requiring, recommending, or suggesting, the registration under this title of any security-based swap agreement[.] ...

3. The Commission is prohibited from ... promulgating, interpreting, or enforcing rules; or ... issuing orders of general applicability; ... as prophylactic measures against fraud, manipulation, or insider trading with respect to any security-based swap agreement[.]

http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

[Heracles 417]

A bank can do whatever they want with their investors money but they should not be able to gamble on or risk any cash that is deposited with them. Why should the FDIC and account holders bear the burden when some dichkead gambles our money, walks away with a hefty bonus, while I lose any money over x amount not covered by the FDIC?

That is what needs to be protected. Not to mention, no single player should ever be big enough to able to take down an entire economy. US financial markets are like the wild wild west. Hence why to this day, not one single dollar of mine is invested in them.

[one...two...tree 2,762]

A bank can do whatever they want with their investors money but they should not be able to gamble on or risk any cash that is deposited with them. Why should the FDIC and account holders bear the burden when some dichkead gambles our money, walks away with a hefty bonus, while I lose any money over x amount not covered by the FDIC?

That is what needs to be protected. Not to mention, no single player should ever be big enough to able to take down an entire economy. US financial markets are like the wild wild west. Hence why to this day, not one single dollar of mine is invested in them.

That's just it. They were gambling with their depositor's money, which was backed by the FDIC. A real recipe for disaster and the reason why we were in the mess in the first place.

[Heracles 417]

A bank can do whatever they want with their investors money but they should not be able to gamble on or risk any cash that is deposited with them. Why should the FDIC and account holders bear the burden when some dichkead gambles our money, walks away with a hefty bonus, while I lose any money over x amount not covered by the FDIC?

That is what needs to be protected. Not to mention, no single player should ever be big enough to able to take down an entire economy. US financial markets are like the wild wild west. Hence why to this day, not one single dollar of mine is invested in them.

That's just it. They were gambling with their depositor's money, which was backed by the FDIC. A real recipe for disaster and the reason why we were in the mess in the first place.

Unless someone opts into a high risk interest account, the funds people deposit should not be used for anything that does not generate revenue using the lowest risk possible. Anyone that abuses that, should take a trip to prison. With all of their assets confiscated and sold. Not to mention anything transferred to someone else in the last 5 years.

Anyone who opts into a high risk accounts, should solely bare the loss or share the profit. Win win for all.

Edited October 15, 2009 by Booyah!

[Heracles 417]

However, we do need another set of regulations ensuring these people don't con average Joe Americans using trickery or cunning loans.

Edited October 15, 2009 by Booyah!

[mRx 16]

This is total BS.

If a bank wants to take huge risks for short-term profits, it's their right to do so in a capitalist system.

Just don't go bailing them out when their trades blow up.

There's no such thing as a "systemic collapse". If Citi, JP Morgan Chase, Bank of America and the

rest of the crooks had gone bankrupt, more responsible investors would have come along and

bought up their assets on the cheap. That's what capitalism is supposed to be about - risk and

reward (or failure).

But of course the Republican-Democrat corporate regime would never let their Wall Street buddies

go out of business.

You're a certified #######.

How would "responsible investors" buy anything at any price when the capital markets were literally on the verge of seizing up? If you can't access your funding account, just how do you buy something?

Money market funds that invested in the commercial paper market had "broken the buck".

"Responsible" businesses were unable to issue commercial paper to keep the normal wheels of business turning, or have you forgotten just how serious things really had become?

The problems of wildly inflated capital markets are reserved solely to inflationary banking systems, scandal--not capitalistic systems.

With regards to capital markets freezing, and an inability to purchase--these claims are unfounded.

-Lehman Brothers, was bought out by the more "responsible" Barclays and Nomura Holdings.

-WaMu, was bought out by the more "responsible" JP Morgan Chase.

These are just two examples that disprove the claim of frozen capital markets.

With regards to a call for more government involvement; I'm with mawilson-- we don't need more of a corporatocracy, but less.

[mawilson 2,133]

What Matt said.

[mRx 16]

A bank can do whatever they want with their investors money but they should not be able to gamble on or risk any cash that is deposited with them. Why should the FDIC and account holders bear the burden when some dichkead gambles our money, walks away with a hefty bonus, while I lose any money over x amount not covered by the FDIC?

That is what needs to be protected. Not to mention, no single player should ever be big enough to able to take down an entire economy. US financial markets are like the wild wild west. Hence why to this day, not one single dollar of mine is invested in them.

That's just it. They were gambling with their depositor's money, which was backed by the FDIC. A real recipe for disaster and the reason why we were in the mess in the first place.

Why not just eliminate the moral hazard, then? Bailouts, the FDIC, the "lender of last resort" Fed, and other schemes meant to socialize losses among the American people enable such risk and wildcat behavior, for they disable the function of "loss" in the profit/loss system.

[scandal 951]

-Lehman Brothers, was bought out by the more "responsible" Barclays and Nomura Holdings

Lehman was bought, but not before the AAA paper they had out in the market defaulted. That, in turn, caused money market funds holding that commercial paper to break the buck (i.e. the value of $1 in a MM fund was suddenly 0.98 cents), which shattered confidence in the entire commercial paper market. Without that confidence just about every operating business in America (and globally) that needed to make payroll or pay for inventory was going to immediately grind to a halt. Those are an awful lot of "responsible" companies, with "responsible" management and employees that were staring at a very very bleak prospect.

Saying that Lehman (or Chase or Citi or Goldman) is too big to fail doesn't mean we care specifically about them - or their management, shareholders or bondholders.

It means we care that if they go down, the effect on Main Street America is too stark to bear contemplating.

Well, so you say that Lehman went down and nothing bad happened. Well- it very very VERY nearly did all go down in flames. To the very great credit of the Treasury (headed by Hank Paulson - a person that history is ultimately going to record very favorably), the Treasury stepped in and essentially guaranteed the commercial paper market, and kept it from total collapse.

As you know, I'm not a Bush lover or a Republican. But I give credit where it is due. Paulson saved America a year ago, much as any great American hero has served his country. You whining theoretical 'pure capitalists' wouldn't last one day on a real trading floor.

Here's a historical account of just what happened those fateful days last September.

http://en.wikipedia.org/wiki/Break_the_buc...eaking_the_buck

The week of September 15, 2008 to September 19, 2008 was very turbulent for money funds and a key part of financial markets seizing up.[1]

[edit] Events

On Monday, September 15, 2008, Lehman Brothers Holdings Inc. filed for bankruptcy. On Tuesday, September 16, 2008, Reserve Primary Fund, the oldest money fund, broke the buck when its shares fell to 97 cents, after writing off debt issued by Lehman Brothers.[2]

The resulting investor anxiety almost caused a run on money funds, as investors redeemed their holdings and funds were forced to liquidate assets or impose limits on redemptions: through Wednesday, September 17, 2008, prime institutional funds saw substantial redemptions.[3][4] Retail funds saw net inflows of $4 billion, for a net capital outflow from all funds of $169 billion to $3.4 trillion (5%).[3]

In response, on Friday, September 19, 2008, the U.S. Department of the Treasury announced an optional program to "insure the holdings of any publicly offered eligible money market mutual fund — both retail and institutional — that pays a fee to participate in the program." The insurance will guarantee that if a covered fund breaks the buck, it will be restored to $1 NAV.[4][5] This program is similar to the FDIC, in that it insures deposit-like holdings and seeks to prevent runs on the bank.[1][6] The guarantee is backed by assets of the Treasury Department's Exchange Stabilization Fund, up to a maximum of $50 billion. It is very important to realize that this program only covers assets invested in funds before September 19, 2008 and those who sold equities, for example, during the recent market crash and parked their assets in money funds, are at risk. The program immediately stabilized the system and stanched the outflows, but drew criticism from banking organizations, including the Independent Community Bankers of America and American Bankers Association, who expected funds to drain out of bank deposits and into newly insured money funds, as these latter would combine higher yields with insurance.[1][6]

[edit] Analysis

The crisis almost developed into a run on the shadow banking system: the redemptions caused a drop in demand for commercial paper,[1] preventing companies from rolling over their short-term debt, potentially causing an acute liquidity crisis: if companies cannot issue new debt to repay maturing debt, and do not have cash on hand to pay it back, they will default on their obligations, and may have to file for bankruptcy. Thus there was concern that the run could cause extensive bankruptcies, a debt deflation spiral, and serious damage to the real economy, as in the Great Depression.[citation needed]

The drop in demand resulted in a "buyers strike", as money funds could not (because of redemptions) or would not (because of fear of redemptions) buy commercial paper, driving yields up dramatically: from around 2% the previous week to 8%,[1] and funds put their money in Treasuries, driving their yields close to 0%.

This is a bank run in the sense that there is a mismatch in maturities, and thus a money fund is a "virtual bank": the assets of money funds, while short term, nonetheless typically have maturities of several months, while investors can request redemption at any time, without waiting for obligations to come due. Thus if there is a sudden demand for redemptions, the assets may be liquidated in a fire sale, depressing their sale price.

[Kathryn41 3,205]

Please try to state your positions without resorting to name-calling - it adds nothing to the discussion and certainly doesn't add any credibility to your position.