Half-stepping: Team Obama starts its dance with derivatives regulation

Back in January, Barack Obama swept into office promising to get the financial system on its feet again and re-regulate it to assure that nothing of the kind happens again anytime soon. The first mission was accomplished, tenuously–and temporarily?–by throwing unimaginable sums of money at financial institutions through lending, spending and guarantees, all of it ultimately backed by the public purse at minimal harm to Wall Street and the investing class. The lessons of the Japanese and Swedish experience over the past 20 years (namely, that protracted systemic bailouts don’t work and that writing down bad debt at the expense of banks and investors is the path to genuine recovery) have been duly ignored all down the line.

With yesterday’s announcement that the administration will pursue derivatives regulation, the other shoe begins to fall. And, big surprise, it’s a soft shoe. The only hard line that Obama’s Wall Street-bred economic team has taken consistently is subordinating the public interest to the wishes of the plutocrats.

Stephen Labaton and Jackie Calmes of the New York Times describe the derivatives push this way: “”The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group. The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.”

Two things. First, the key word there is that “many” in the first sentence. Here’s the loophole (NYT again): “The administration plan would not require that custom-made derivative instruments — those with unique characteristics negotiated between companies — be traded on exchanges or through clearinghouses, though standardized ones would.”

And second, the proposal really seems directed at making derivatives markets more rational and efficient. If the regulatory package that emerges is truly as advertised, it would likely depress the trade in derivatives for a time–until a new set of products and practices evolved to fly below the government’s radar.

As half-measures go, depressing the trade in derivatives, and thus reducing the systemic risk they pose, would be a good thing. But why stop there? What is the social good that’s accomplished by facilitating their survival in any form? Derivatives have always been touted as a means of reducing risk and promoting the flow of capital. But as we’ve learned from the past year, there is no such thing as a derivatives market that can reduce systemic risk in a crisis, because when the whole system goes south, no one can pay off on their derivative contracts and they become just another monstrously expensive class of bad debt.

And that’s to say nothing of the fact that a lot of derivatives trading is pure gambling–bets on the performance of financial assets placed by people and institutions who have no stake whatsoever in those underlying assets. (During a February congressional turf battle over a bill on derivatives regulation, Minnesota Rep. Collin Peterson’s ag committee killed a provision that would have prohibited these “naked” trades. And Wall Street remains resolute in its opposition to any such ban.)

The logic of “risk management” through credit default swaps and other derivatives contracts is to mitigate the risk attached to expanding debt past levels that seem wise by conventional measures. Another way of putting it is that derivatives exist to prod the financial system into more debt and more stratospheric degrees of leverage. Is that really the path to a prudent, responsible, stable financial system? Is it how we should go about trying to put the bubble years in our rear-view mirror?

I vote with Warren Buffett on derivatives. Here’s what he said on the subject in his March letter to shareholders:

“Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks…

“Improved ‘transparency’–a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks–won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.”

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Comments (3)

  1. Submitted by Steve Titterud on 05/14/2009 - 11:31 am.

    I learned a new term from Jared Diamond in his “Guns, Germs and Steel” – kleptocracy.

    Wikipedia offers the following definition:

    “A kleptocracy (sometimes cleptocracy, occasionally kleptarchy) (root: klepto+kratein = rule by thieves) is a term applied to a government that extends the personal wealth and political power of government officials and the ruling class (collectively, kleptocrats) at the expense of the population.”

    Is there a better description of what we have before us now?

    To all the kleptocrats who feared things might change after the Bush years – not to worry!! This form of government is in great shape.

  2. Submitted by Glenn Mesaros on 05/15/2009 - 08:25 am.

    In an interview with the New York Times magazine, published on April 29, President Barack Obama questioned whether his own grandmother’s hip replacement before her death was justified. In the same interview, he cited the banking system of Canada, in opposition to Franklin Roosevelt’s Glass Steagall Act.

    In the April 14 interview, Obama questioned whether expensive procedures for the terminally ill reflect a “sustainable model” for health care. “You just get into some very difficult moral issues” when considering whether “to give my grandmother, or everybody else’s aging grandparents or parents, a hip replacement when they’re terminally ill. That’s where I think you just get into some very difficult moral issues. The chronically ill and those toward the end of their lives are accounting for potentially 80 percent of the total health-care bill out here.”

    This was the same defense of Nazi doctors at the Nuremburg trials.

    Although Obama claimed that he would have paid out of pocket for his grandmother’s hip replacement “just because she’s my grandmother,” the message was unmistakable. Obama is willing to cut costs by letting the terminally ill die.

    This attitude is not unrelated to his endorsement of “ruthless pragmatism” with regard to economic policy, and his rejection of Franklin Roosevelt’s Glass Steagall Act, which had the effect of protecting legitimate commercial banking from the predator practices of investment bankers.

    “When it comes to something like investment banking versus commercial banking, the experience in a country like Canada would indicate that good, strong regulation that focuses less on the legal form of the institution and more on the functions that they’re carrying out is probably the right approach to take.”

    The Wall Street Controllers of Banker’s Boy Barack are laughing all the way to the bank.

  3. Submitted by Susan Oehler Seltzer on 05/15/2009 - 11:44 am.

    Thank you Mr. Perry and others for your coverage and comments on this most critical issue. Sometimes, “experience is the best teacher.” and things get so obfuscated, it is hard to see that the “Emperor has No Clothes.”

    I am not an economist, nor a bank executive, but I have over 7 years direct experience in the swap field and direct experience in monitoring counter-party credit risk in swaps at a major U.S. Bank. I submitted written testimony to Congressman Peterson’s proposed Derivatives Transparency Act of 2009, in February 2009 and am shocked this legislation has not yet been debated by our Minnesotan Congressional delegation in our local press.

    As I testified in February, “There is a viable and valuable use for interest rate swaps and foreign exchange swaps and forwards in hedging interest rate and foreign currency exposures. Credit default swaps cannot effectively hedge credit risk. Credit risk, as you are aware, can only be managed by looking at the financials of the entity, at the time of credit extension and on an ongoing basis as market conditions change. Market sentiment developed through trades establishing “an entity’s credit worth” has proven to be destructive to our financial system and their advocates have not demonstrated what value the continuing use of them will bring to our financial system. There is far greater downside, than upside, in continuing their use.”

    Ok, maybe I am not correct, but I assumed at a minimum, Congress would have public debate on the pros and cons of using credit default swaps, given that they played a major role in destroying our global financial system, now restored through U.S. taxpayer expense.

    I wrote my Representative Erik Paulson and m Senator Amy Klobuchar several times saying it was critical this informed, public debate occur. I have not yet heard from them on their position on this issue, despite numerous requests. I do not believe an opinion has been posted on their public web sites.

    The Derivatives Transparency Act of 2009 was never taken up for public debate by the House Financial Services Committee. The Senate never held public testimony on the pros and cons of the use of “naked” credit default swaps and the risks to the American taxpayer in continuing the use of unregulated, customized credit default swaps.

    Given the tremendous resources (billions of dollars) the U.S. taxpayer has provided to shore up counter-parties, I still believe we need to hear an opinion from all Minnesotan Congressmen/women on the ROI of taxpayer dollars already used to fund credit default swap counter-party payments and the value to the U.S./Minnesota economy of the future use of “naked” credit default swaps on a defined risk/reward basis.

    In sum, why should we continue to allow this non-transparent risk taking and why should we support FDIC Chairwoman’s Blair’s most recent proposal that U.S. taxpayers set up a future fund to bail-out the counter-parties that fail in their counter-party risk-taking on credit-default swaps? It appears we are going the wrong direction in supporting this non-transparency.

    At a minimum, Minnesota Congressmen, please give us the ROI on why we should continue to fund past and future counter-party credit-risk failures on credit default swaps and set-up an FDIC fund for this purpose?
    It is my understanding since Minnesota Congressmen/Women are not hearing from their constituents on the Credit Default Swap regulation, they are not getting informed or taking a position.

    Is it not worth every Minnesotan’s time to write their Congressman and ask for them to publicly state their position on the ban of “naked” credit default swaps and the future use of customized credit default swaps, that are not traded on a regulated exchange?

    Without public debate on this issue, there may not be anything left over to fund the necessary Social Security funding needs, world class education needs and safety nets, for those less fortunate, we have worked so hard to build over the years.

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