A Blank Spot on the Map

Sunday, July 12, 2009


Christopher Whalen of Institutional Risk Analytics

When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or “CDS” contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another. You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or “CDOs,” for these too are OTC “derivatives” that purport to derive their “value” from another asset or instrument.

2) Bank Business Models & OTC

Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.

The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage – but are net destroyers of value for shareholders and society even while pretending to be profitable.

Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange.

The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the view of these agencies are largely duplicative of the views of JPM and the large OTC dealers .

3) Basis Risk & Derivatives:

The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or non-existent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the “basis” of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection.

With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ “models” that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.

In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing.

To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, “The Failure of the Economy & the Economists.” He describes the CDS market in a very concise way and in layman’s terms. I reprint his comments with the permission of NYRB:

“The most telling example, and the most important in accounting for today’s financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.
“But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars’ worth of economic costs that would not have occurred otherwise.

“This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today’s immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers’ money if they have bet the wrong way. But here as well, no one seems to be paying attention.”

4) CDS & Systemic Risk

While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

Seen in this context, AIG was the most visible “sucker” identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers.


Post a Comment

Links to this post:

Create a Link

<< Home