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Over-The-Counter Attack

May 14, 2009
By

Yesterday, just about 15 years after the General Accounting Office warned it was necessary, Treasury Secretary Timothy Geithner sent a letter to regulators expressing President Obama’s interest in regulating the market in Over the Counter Derivatives.

The news spent a few hours on the front of New York Times’ web page before being relegated to the nation and the business sections, but it was arguably bigger news than the death of William Seidman, the long time Republican financial and political operative who, as head of the Federal Deposit Insurance Corp., created and ran the Resolution Trust Corporation to clean up the Savings and Loan scandal in the early 1990s.

Seidman’s RTC-which Seidman (along with other worthies such as Paul Krugman) advocated as a model solution to our present troubles-is now regarded as a triumph. The government unsentimentally nationalized the failed thrifts and banks, closing many of them despite their claims of profitability (“we knew they were lying,” says the chief investigator from that simpler time). The bad assets were parceled off at fire-sale prices to investors (many of whom were connected and corrupt, but whatever). The cost to taxpayers was about $130 billion-or about three-fourths the AIG bailout so far.

The RTC is remembered as calm wisdom today, but in the early 1990s it was seen differently. Critics on both the left and right howled about the scams shrouded by the fast-moving, hugely expensive program. The cartoonist Mark Alan Stamaty posited that FDIC stood for “Free Dough If Conned.”

In hindsight it appears that Seidman got it mainly right, even presciently so. In his 1993 memoir he advised: “Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”

Which brings us back to Over the Counter (OTC) derivatives.

Derivatives are just futures contracts and insurance policies written up so that their issuers do not have to do the things (have money, for example) that insurance companies are supposedly obligated by regulation to do. “OTC” just means they’re private contracts, unmonitored by any central regulator or clearinghouse. So, OTC derivatives are secret futures and insurance contracts.

Though often (incorrectly) regarded as inscrutably complex, derivatives are easy to understand in principle. The contracts serve as betting slips, and can be used to ameliorate risk or to secretly magnify it, and they magnify the apparent amount of money in an economic system. (See my “Murray The Drunk” illustration here).

Geithner’s proposal is just that-a toe dipped in political waters to check the temperature. It bears noting, then, that it was no secret among those who make their livings trading this kind of paper. The Times‘ story covers the ground well enough, but its story misses a few points, such as the historical significance of the 2000 Commodity Futures Modernization Act. The Times tells us:

The law came about after heavy lobbying from Wall Street and the financial industry, and was pushed hard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary, Lawrence H. Summers, who is now President Obama’s top economic adviser.

Well, yes, plenty of bipartisan blame to go around. But the key architect of this was Sen. Phil Gramm (R-TX), whose wife sat on the audit committee of Enron’s board of directors. Remember Enron? So quaint it seems now. Enron imploded because of off-balance sheet deals constructed mainly of OTC derivatives, including interest rate “swaptions” and credit-default swaps. The instruments were kept unregulated by the good graces of Ms. Gramm, who exempted them circa 1992, when she headed the Commodity Futures Trading Commission. Right after that she joined Enron’s board. Phil Gramm’s 2000 bill “modernizing” the commodities act contained language specifically exempting energy derivatives. Congressional staff called that part of the bill “the Enron Point.”

The Times continues:

At the time [in 2000], the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts across the world-a measure that counts the value of a derivative’s underlying assets-outstanding at the end of last year totaled more than $680 trillion, according to the Bank for International Settlements in Switzerland.

OK, two things wrong. The “notional” value explicitly does not measure the derivatives’ “underlying assets.” Notional means the value of all the contracts in aggregate which, because many contracts can be written on any single asset-and can even be written on the value of the derivatives contracts themselves-is many multiples of the value of the assets underlying. And the notional value of the OTC derivatives market was, by 1999, already frighteningly huge—some $80 trillion—as I reported at the time. That amount was already more than 12 times the amount of money earned by every human on the planet, though admittedly, perhaps less insane than the notional amount outstanding today, which is about 100 times the value of all wages, salaries, bonuses, interest and investment income earned globally.

The Times then oversimplifies derivatives’ problem:

Used poorly, derivatives can backfire and spread risk rather than contain it.

Right. But “poorly” implies some error, some miscalculation on the part of one of the contract’s parties. In fact, what spread the risk was the overuse of derivatives to speculate—to gamble, and to fix the game. Incidentally, such game-fixing attempts may have been what ballooned the notional value of OTC derivatives beyond any human comprehension, as the players conjured bundles of contracts large enough to move commodities markets, or to take advantage of their sudden movements. So a wheat farmer’s use of a futures contract to lock-in an acceptable price for his crop or a cooperatively run public utility’s taking a futures contract on natural gas to hedge its exposure to price volatility are routine, defensible uses of derivatives.

But if a giant market maker like Enron uses derivatives to manipulate the gas or electricity markets to reap billions of dollars, that would, in the Houston of 2000 or in the Greenwich of today, be considered not a “poor” use of derivatives but a “brilliant” use, and would earn its author at least a seven-figure bonus even as the state of California faced rolling blackouts and bankruptcy. Bringing these contracts into the light could prevent the abuses of last decade, but the logic of “financial innovation” suggests that the fixes will be short-lived at best.

Geithner’s letter makes much of the idea of a “standard contract” for derivatives versus “customized” contracts, which he opines should not be used simply to get around any new regulations.

But OTC derivatives-the kind a hedge fund or an Enron uses-are (or can be, with a bit of lawyering) all “customized.” The beat goes on.

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