Proving once again that the early bird gets left in the starting gate, Mickey Kaus presents a rebuttal from "emailer Z" to the David Corn piece he flagged last week before I got around to it.
Corn's gist - it was Phil Gramm, adviser to John McCain, that almost singlehandedly spawned the current banking meltdown by pushing legislation that exempted certain types of swaps from regulation by the CFTC and the SEC. A useful attack if he can make it stick, since that absolves Democrats of any complicity.
However, emailer Z makes one obvious point - bank deregulation has had bipartisan support for quite a while.
A second point, which I get to eventually, is that the scary products like credit default swaps were neither spawned by this bill nor as scary as described in a couple of article floating around.
But don't think for a moment that I intend to shy away from the obvious. Let me just mock this modest understatement from Corn:
Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.
I will come back to "no one made sure the banks and hedge funds had the assets", which is half-ludicrous. Meanwhile, what's this about "Gramm's bill", "supported" by Treasury secretary Larry Summers? Get me rewrite! The CFTC released draft regulations in 1998 which met with resistance from the financial community. The President’s Working Group on Financial Markets, composed of the representatives from the Treasury, the Federal Reserve, the SEC, and the CFTC, asked Congress to sit tight until they could deliver a report, which was presented in November 1999. By June of 2000, as per this hearing, most of the Working Group requests had been incorporated into the Commodity Futures Modernization Act of 2000. Let's go to Phil Gramm for an explanation of the fundamental problem:
We want legal certainty for swaps. Most people do not know what swaps are. I am almost incapable of fathoming the volume of swaps in dollar value. When I heard the number as we first started discussing this issue, I was convinced that an error had been made and that someone had mistakenly said trillions instead of billions; I was wrong. This is a huge, critically important markets, and we cannot allow uncertainty about the enforceability of these contracts to stand.
We are all aware that uncertainty occurs because of the off-exchange trading prohibition in the Commodities Exchange Act. If the Commodities Futures Trading Commission deemed these swaps to be futures, that would create this legal uncertainty.
I believe that a similar uncertainty could be created if the SEC deemed them securities and then argued that they were being traded without fulfilling the reporting requirements of the Securities and Exchange4e Commission statute.
Market practice had been to act as if these over-the-counter derivatives were, in fact, not subject to either CFTC regulation as a futures contract or SEC regulation as a security. However, the hovering cloud was that some market participant, perhaps a hedge fund, would try to wriggle out of an contract that subsequent market movements had made unfavorable by calling in the lawyers and arguing that the entire contract was void, based on non-compliance with CFTC rules or SEC registration procedures.
As a legal strategy this was a long shot, but some bank officers and regulators had an odd quirk that probably helped them attain the positions of responsibility to which they had risen - when they were advised that such a legal ploy would almost certainly fail, they somehow heard "might possibly succeed". Hence a desire for legal clarity, as provided by this bill. And let's note that suitable legal clarity was available in certain European markets, but the Congress and US regulators were not interested in seeing the whole market move offshore.
The idea that the resulting bill was Phil Gramm's brain-child is absurd. It basically emerged from the Clinton Working Group, with a Treasury then headed by Larry Summers. However, any sensible Democrat, when confronted with an economic question, asks the obvious - What Would Bob Rubin Do? I assure you without even looking it up that Citigroup, Rubin's post-Clinton home, was a huge player in the unregulated derivatives market and would have enthusiastically backed this bill, as did the CFTC. Go with emailer Z on this one - the gist of this bill had broad bipartisan support. Someone might check Sen. Schumer and Rep. Rangel (and I will eventually), but I'll promise they backed it.
COMPOUNDED WEIRDNESS: Is there a memo circulating to push this Gramm-McCain attack line? Here is David Corn, May 28, promoting Foreclosure Phil as the architect of the current banking debacle; here is Patricia Kilday Hart of The Texas Observer on May 30 with substantively the same article.
The always interesting 'Hilzoy', normally found at Obsidian Wings, is guesting at the Washington Monthly and promoting the Texas Observer piece. I haven't the will to engage all of her misconceptions, so let me tackle the central ones:
But Gramm's legislation also seems to have legalized what are known as 'credit default swaps':
Hardly - this bill clarified their legal status, but they were not "illegal" prior to the bill.
In a normal, regulated insurance market, there would be requirements that (for instance) X have enough capital to make good if my loan defaults. X would also not be able to sell the contract to make good my losses to just anyone, and X would certainly have to tell me about any such sale. But in the world of CDSs, neither requirement exists. CDS contracts can be sold and resold, and I might have no idea who is actually supposed to repay me if my loan goes into default.
Again, no, although her misconception is based on a similar misconception at the Times and TIME. The reported volumes of swap contracts are huge because most swap dealers, most of the time create new, equal and offsetting contracts when they want to "sell" a position.
For example - suppose JustOneMinute Enterprises is a sufficiently large and impressive entity that major swap dealers consider me an acceptable swap counterparty. I may choose to enter into a credit default swap with JP Morgan Chase in order to hedge an exposure to, for example, the risk of a default by General Motors on its bonds. Let's imagine that JustOneMinute Enterprises owns some General Motors bonds and buys credit protection from JP Morgan Chase.
JP Morgan Chase is a major derivatives dealer and may have any number of positions which offset their swap with me. However, suppose they want to "sell" my swap at a profit. The much more common approach would be for JP Morgan Chase to enter into an
equal but opposite swap with some other customer or dealer. For example, they may have found a bold bond investor, Buccaneer LP, who thinks that from here on out General Motors bonds can only go up; this visionary will happily sell credit protection to JP Morgan Chase.
JP Morgan Chase has thus both bought and sold the credit protection, presumably at a net profit. But are they out of the deal, and do I care about the party to whom they sold it? Per Hilzoy, who says that "CDS contracts can be sold and resold, and I might have no idea who is actually supposed to repay me if my loan goes into default", I have a new contract with Buccaneer LP.
In reality, however, I continue to have a contract with JP Morgan Chase, as does Buccaneer LP. JP Morgan Chase will achieve its profit only if both its counterparties (JustOneMinute and Buccaneer) make their payments as scheduled. Consequently, JP Morgan has an ongoing credit relationship with both counterparties; as the value of the credit protection changes, one party owes payments to JP Morgan and the other will be a recipient.
There is quite a bit of logic to this, actually - the fine team here at JustOneMinute has never heard of Buccaneer, and I daresay they have never heard of us. However, we are both happy with the highly-rated JP Morgan as a counterparty. Up above I noted that sometimes the counterparties are formally substituted - this is a legal process known as "Assignment and Novation", and contra Hilzoy and the Times, all parties must consent. And why might they consent? Personally, I would never consent to a substitution of Buccaneer for JP Morgan Chase, but I might agree to let JP Morgan Chase switch me to Citigroup, especially if the price was right.
Hilzoy goes on:
This is just a recipe for instability: for allowing unregulated financial institutions [such as hedge funds] to place themselves, and the rest of the financial universe, at risk through unregulated, highly leveraged, and deeply risky maneuvers.
Well. In reality, a day may come when Buccaneer owes JP Morgan a billion dollars on its General Motor credit default swap, and JP Morgan owes a similar amount to me (I told you I was big...). Do I care whether Buccaneer is good for the money? Not really - I care only if I can imagine that their default will bust JP Morgan, and a billion dollars won't do it. As long as I believe that JP Morgan can pay me, I am not worried about how or whether they collect from their counterparties.
I am not saying there is no problem with this market, but it is not the problem described by Hilzoy, or here by Corn (my emphasis):
But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.
Wrong again. Hedge funds are unregulated, and these contracts were unregulated. However, it does not follow that banks themselves were not subject to regulatory review - the Fed and the FDIC review banking practices, not specific products, and if they don't like the way a bank is monitoring its credit default swaps, or interest rate swaps, or foreign exchange, they can prompt that bank to pause and refresh its procedures.
Now, one might worry that the Federal Reserve was trying to monitor banking exposure to the credit default swap market with incomplete knowledge since it could see the positions of the banks under its regulatory umbrella, but not the positions taken by those bank's counterparties. For example, the Fed would have been in a position to see that Buccaneer had huge swap exposures to five different US money-center banks, if that were the case. However, if Buccaneer had dramatic exposure to one US bank, two US investment banks, three US insurance companies, and four foreign banks, it is possible that Buccaneer would not produce a blip on anyone's radar unless they actually crashed.
I RELENT A BIT: In saying that Hilzoy, the Times, and TIME are all wrong about strange, unknown parties suddenly popping ups as the other side of a credit default swap, I am right, and this sort of nonsense from TIME is, well nonsense:
Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.
However, I am right subject to a modest caveat. Based on this article from 2005 I will infer the following:
First, there was a huge back-office backlog of confirmations; secondly, hedge funds would pretty routinely assign their side of a deal to another dealer, figuring that everyone wins and will consent. For example, suppose Buccaneer had a now-profitable trade with JP Morgan Chase and wants to realize the by "selling" it to Goldman Sachs. One way would be to enter into a brand new contract between Buccaneer and Goldman; a second would be to get Buccaneer out of the deal and simply have Goldman pay Buccaneer for the right to take over Buccaneer's contract with JP Morgan Chase.
JP Morgan Chase will very much insist on being notified and giving consent (as per their contractual right) because they do have credit lines and limits with Goldman Sachs. However, as a practical matter, JP Morgan Chase will almost surely consent eventually, because Goldman is almost certainly a more credit-worthy entity than Buccaneer (similarly, Goldman would much prefer JP Morgan Chase as its counterparty).
From the article:
Typically, hedge funds assign their positions on CDSs and other over-the-counter derivatives contracts to third parties, usually other dealers. But dealers say the hedge funds have generally been slow to inform the original parties involved in the deal, which has resulted in general confusion. They say this is the single largest factor in the rising mass of unconfirmed trades, with some parties claiming it took an average of 25 days just to receive notice of an assignment before regulators began to increase their scrutiny of the situation.
It appears that counterparties with the dimmer credit picture were routinely assigning their deals to higher-rated dealers based on a presumption of eventual consent. However, that was problematic:
The development of the Isda novation protocol, confirmed on September 13 , just two days before the Fed meeting, was designed to ease the assignment confirmation process by simplifying the transfer of existing trades. Previously, assignment trades required the written consent of all parties, but the new guidelines seek to ensure written evidence of consent is received by close of business on the novation trade date. Market participants have broadly welcomed the initiative, which had the backing of the 14 dealers mentioned in the Fed letter.
Lots of background here. TIME and the Times were writing in 2008 about a practical, but not legal, problem that was addressed in 2005. And I will promise you that as a matter of market practice, if Goldman Sachs called up JP Morgan Chase and tried to explain that JP Morgan Chase had a new counterparty to what had once been their deal with Goldman Sachs, to wit, Nevva Hoyd Ofem, Inc, JP Morgan would decline the assignment. After they stopped laughing.