Pretending to Regulate Derivatives
Treasury Secretary Geithner has launched a push to install clearinghouses as the weapon against systemic collapse of the derivative markets. As with all of the financial repair missions of the Obama Administration, this happened after extensive consultation with all the people who really believe the financial system should work for the financial elites, and their lobbyists. It doesn’t bother them if taxpayers eat clearing house losses in the next disaster.
Clearinghouses are supposed to remove counterparty risk by inserting a third party between the parties to derivative transactions. Counterparty risk is the risk that one party can’t perform on its obligations under the derivative. The idea is that the clearinghouse will perform if the one party can’t. AIG is the example: it couldn’t perform on its credit default swaps, and the financial elites ran crying to Bush and Paulson to get taxpayers to perform for AIG, which worked out well for them, but not so well for the rest of us.
What could possibly go wrong? Well, for one thing, how does the clearinghouse get enough money to perform in the event of an AIG-type disaster, right now in the range of $80bn? One clearinghouse explains that the money will eventually come from the other players in the market. That won’t happen. They’ll just run back to their buddies in the Treasury to get taxpayers to do the paying.
But that isn’t all. Treasury will only force “standardized” derivatives onto exchanges. Customized derivatives will not be publicly traded; instead, general information will be reported to a depository, which will make some information public, but most will only be available to regulators, and we know how well that works. And there is a worse problem. This distinction was first made by Wendy Gramm, Phil’s wife, when she was head of the CFTC, and eventually the standardized category shrank so much it was drowned in the bathtub when President Clinton signed the law deregulating derivatives. Frank Partnoy explains the danger in the NYT:
The leading derivatives lobbying group, the International Swaps and Derivatives Association, is already looking to exploit the Treasury’s proposal to split derivatives markets in two. As part of its lobbying campaign to protect negotiated instruments, it insists that last year “the derivatives business — and in particular the credit default swaps business — functioned very effectively during extremely difficult market conditions.”
Sure, as long as you ignore AIG. Oh, and Merrill Lynch. And anyone else we don’t know about because, don’t you know, this stuff is a big secret. Let’s go to the tape. This chart shows free public information on credit default swaps:
Markit Group has developed this free "Last Quote for the most Liquid Credit Default Swaps" pricing report to address a public interest in CDS prices. This Last Quote report is based on the most recent price quote any active dealer in the CDS market provided to its institutional customers before 4:00PM Eastern.
This chart doesn’t tell us anything about how much trading there is in these things. We know nothing about that from public information. Here is the report from ICE, the US clearinghouse. From this we learn that a grand total of 11 CDSs are trading, all of them indices. None of them are single-name references, which is the kind we would find interesting. If that is the public data we will get under the Geithner plan, we didn’t make progress.
And, here is the question no one even bothers to answer: what is the cost-benefit analysis for these things? Yves Smith at Naked Capitalism asks the question in great detail here, and her commenters, many of them knowledgeable, give stock answers. Nobody explains the benefits, it’s as if they are taken for granted. No one says the risk is controlled, they merely say it is reduced.
The financial elites act like they know how to manage risk, they talk about their desire to balance their portfolios by acquiring risk at particular levels and spout gibberish about VAR and “stress testing” and other control measures. Again, we’ve seen how that works out. We also have a theoretical explanation of why their “risk management” is worthless prattle. As best I can tell, the geniuses on Wall Street have only a superficial understanding of the mathematical models on which their trading, and their risk control, are based.
The President and the Treasury don’t have to answer, they don’t bother to explain why this nuclear waste is worth the risk to taxpayers. They just do what the financial elites want them to do. And Congress will join in four-part harmony, dancing to their their Master’s tune. Lord knows both groups, Republicans and Democrats alike, have taken enough money that it would really be surprising if they didn’t do what the financial elites want them to do.