Mickey Beats Me To It (I Beat It To Death)

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 [2005], 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.

 

Comments

[Rick Ballard]

So, are the Lehman counterparties, the ones exiting, that is, privy to information which has not been provided to the "trading public" as a whole due to inadequate regulation?

I wonder if JPM's tummy has settled down sufficiently to be able to gobble up Lehman as they did Bear Stearns?

[DES]

The CFTC investigation was started over food prices. They added to the oil because no one wants to pay for their drug.

[DES]

The CFTC investigation was started over food prices. They added to the oil because no one wants to pay for their drug.

[DES]

Sorry.

http://english.aljazeera.net/NR/exeres/89419F96-23CD-4396-8BE1-FBE2DC449C80.htm

[DES]

The posting ruins the web and you can't use the back button.

Anyway, the point of the investigation of the oil is the lobby tried to tie food prices into oil prices, so they investigate food and oil commodity exchanges saying the prices should go down. All the prices go up when they investigate and always have; so watch oil and food go higher. The key to oil is not transport of the food, but the refining. Oil from food. So, more refineries, but we can't because of national security and the producers can't because of national security. So, food becomes a national security issue like the climate and we start a new intelligence agency after they give Congress a favorable report like the Geo spacial intelligence agency. We could call it the Food Security Intelligence Agency after the bills override. We can hire all those lobbyists that ran up the price.

The and Arnold is in trouble cause he didn't stop Colorado from having to pay full price for the Damn work and they had to use matching funds. California doesn't care about food, just their houses.

[Charlie (Colorado)]

Is there a memo circulating to push this Gramm-McCain attack line?

Nah, y'think?

[ParseThis]

Let the Sunshine In

[Clarice]

I take it this is this election's Halliburton...
Throw in some mumbo jumbo and names of big corporations, accuse the Rep candidate or people close to him of something really bad with a big corporation and rest assured the muddled press and voters will fall for it like a ton of twits.

[boris]

rest assured the muddled press and voters will fall for it like a ton of twits

Against muddle twittery even the gods JMH would struggle in vain

[vnjagvet]

Tom:

Thanks for understanding this and explaining it.

Clarice:

If this is the latest Halliburton, good luck to the Corn's of this world getting it across to JQ Sixpack, et al. Personally, I don't think it is a bit complicated to take hold as a general election issue. It happened under Clinton's watch. Where's the hook into McCain?

[glasater]

TM--Thank you for doing yeoman's work in writing this post. The talking heads at CNBC could use you as a guest host:-)

I await Cathf's comment/s and her "take" on this subject.

[bgates]

vnjagvet -
64 TRILLION DOLLARS mumble mumble RISING TIDE OF FORECLOSURES mutter mutter MCCAIN, MEMBER OF 'KEATING FIVE' mumble mumble KEN LAY mutter mutter REPUBLICAN mumble mumble....
Who says the hook has to make sense?

[vnjagvet]

Yeah you're right, bgates. [slaps head exiting stage left]

[cathyf]

A couple of additions/clarifications:

1) The whole reassignment thing can happen all at once when the swap is originated. Example: Suppose the parties are Customer, AABank and AAABank. A salescritter from AABank goes out and sells some derivative to Customer. But the derivative is structured as a transaction between Customer and AAABank, with an identical position between AAABank and AABank. Customer pays more for the derivative because of the triple-A credit rating as opposed to the double-A credit rating. AABank and AAABank split the difference between the double-A and triple-A price according to whatever they hammer out. Typically, the two banks will have an extensive series of motley and assorted positions between them, so a key question will be whether the new position adds to the credit risk that they have with each other, or it reduces the exposure that they have to each other (which is the job of the portfolio risk managers to figure out.)

2) As can be seen in the previous example, an institution's credit rating converts into cash on the barrelhead. The assertion that they are "unregulated" because some particular bunch of bureaucrats from some particular agency of some particular government doesn't have oversight is downright silly. The key regulators of the global financial system are the credit rating agencies. (And the reason that we have a mortgage market debacle is precisely because the rating companies fell down on the job on a massive scale.)

3) It's not just that foreign banks are involved in these transactions, but even foreign governments. (Sovereign risk is better than triple-A for most 1st world countries.) Any congresscritter who thinks that we can send the American CFTC to audit the books of a European government's treasury needs a whack upside the head with a clue-by-4.

4) (this is picyune...) Phil Gramm says: "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." I think he was probably right the first time, in that people exaggerate the value of the derivatives market by conflating valuation with notional amounts. Take a typical fixed-for-floating interest-rate swap. Typically, they are put on such that they are worth zero at the beginning. Suppose the floating rate is 2% at the beginning. Then at the first 6-mo coupon it has slipped to 1.875%, so party A pays party B 0.125% of notional. That's 625 million. Then the next coupon comes and the rates are back at 2%, and so the coupon is zero. And then the next coupon, and the interest rate goes to 2.0625%, and now party B is paying party A 325 million. All of a sudden we've gone from a trillion to a couple hundred million.

The whole point of swaps is that they have offsetting sides made up of things which are close, but not exact, substitutes for each other. Because they are such close substitutes, the value of the position has to be orders of magnitude smaller than the value of the underlying notional amount.

[glasater]

Cathyf--I knew you would come through:-)

[Don]

Corns makes a huge deal of the Commodity Modernization Act while he conveniently downplays the repeal of Glass-Steagall. Corn quotes Greenberger, who pretends as if his version of the CMA actually had a chance at passing. Then Corn implies that Gramm gamed the system to have a toothless CMA passed into law. That's bull***t. There's no way that Greenberger's version of the CMA was EVER going to allow the CFTC authorization to regulate OTC derivatives. Corn and Greenberger ignore the fact that the SEC, President Clinton, Greenspan, and Rubin were ALL against it. They were afraid that if the US regulated OTC derivatives, the US would lose all of that business to London, which has happened to large degree anyway.

What Corn downplays is the repeal of Glass-Steagall, signed into law by President Clinton in 1999. The law that repealed Glass-Steagall allowed companies with insured bank deposits to merge with investment banks/brokers, which allowed financial supermarkets like Citigroup and others with FDIC-insured deposits to become huge players in the deregulated OTC derivatives market.

What's really interesting is how Corn downplays this, even when the act that repealed Glass-Steagall is called the Gramm-Leach-Bliley Act. The act has Gramm's name on it for crying out loud. Why isn't Corn going nuts over this legislation??

[trilobite]

cathyf, IANAE, and no doubt you understand more about credit swaps than I do. But how exactly do you figure that private industry, credit rating agencies, are "regulators"? They can't give orders, nobody oversees them, they don't issue guidelines (just ratings) - this seems unlike regulation as I know it. And why is it "downright silly" to say that when Congress orders the agency that normally regulates securities not to regulate these securities, they are "unregulated"? Sounds more like the ordinary meaning of English words to me. Not regulated by the appropriate agency = unregulated. You don't explain or even hint at why this is wrong, much less "downright silly."

And what's with the mockery of "some particular bunch of bureaucrats from some particular agency of some particular government"? Is there some other bunch of bureaucrats that would be better? Is regulation best acccomplished by having ALL the bureaucrats of ALL the agencies of ALL the governments weigh in? That seems, um, downright silly. Perhaps I am missing something.

Or perhaps you just despise regulation and are trying to pretend that it has no place in the market?

Tom, your post is somewhat reassuring, but I still don't see why it was necessary to take what look to a layman like some kind of securities and exempt them from securities regulation. I'm sure it made trades easier, but only by removing the usual methods of oversight and verification of assets.

Your reasoning seems to boil down to, nobody would ever be that stupid, and if they were it would show up somewhere else eventually, so we might as well not take precautions. The same reasoning would, of course, support abandoning any particular safety feature in any field. Yet it turns out people often are that stupid, and eventually is often too late. Why is it especially helpful to have no direct regulation in this particular market?

[Rick Ballard]

Trilobite,

Credit rating agencies perform the most ruthless form of regulation in existence when they are functioning properly. They have also functioned at least as well (please read "much better") than the regulators who bend to the whisper of a pol.

If you don't believe that credit raters exaction of a pound of flesh for misconduct is ruthless, then you haven't paid attention as value of a company which misteps is decimated overnight.

[cathyf]

Congress orders the agency that normally regulates securities not to regulate these securities

That's the "downright silly" part... If you have Deutsche Bank marketting a EUR-JPY FX swap to a Japanese company, with the Lichtenstein treasury acting as the counterparty to both sides for a fixed cut of the profit, then "Congress" (as in the US Congress) and "the agency that normally regulates securities" would have no place there. You know, since Germany, Japan and even Lichtenstein are sovereign nations and don't take kindly to us ugly Americans sticking our noses in their business.

[cathyf]

Rick, it's not just the "decimation" function, which is the blunt instrument form of behavior modification, and closer to what regulators do. With regulators, the institutions's practices are graded on a pass/fail system -- either they are fine, or the institution has to stop them. With the rating agencies there are lots of gradations of scale. Being a double-A rated institution is fine and honorable, but you make a little less money on every trade than if you are triple-A rated.

Credit ratings are a far more delicate instrument than any regulatory regime. (Well, than any financial regulatory scheme. County health department inspections with their numeric scores are pretty detailed, too.)

[trilobite]

cathyf, thanks for the response. I do understand that a lower credit rating can put a big hurtin' on a company, and that a CRA can modulate the level of pain. OTOH, regulators can go after very specific misconduct, prescribe remedies, force transparency, and anticipate trouble from failure to follow the rules. That last has its downside, but it is liable to catch problems before a credit agency would notice it, especially if the CRA has no filings to review. There's also the problem that the credit agency has no oversight. You say S&P failed - okay, what is the consequence to S&P? Probably none, especially since there's not really much competition in that field.

There may be a good argument for why CRAs are so good at this that regulation is unnecessary, but I haven't heard it here so far. What you seem to be saying is, CRAs screwed up, they won't suffer for it, but they're still better than regulation because they are so good at what they do. Huh?

As for your Deutsche Bank/Japan/Lichtenstein question, surely you are not saying that all credit swaps are among foreign entities. May we not at least regulate our own entities?

[Forbes]

ZZZZZZZZZZzzzzzzzzzzzzubbubhuhgulp...Gee Tom, this is almost as interesting as one of your old Plame Name Blame Game Flame-outs! But I'll try to stay awake during class, promise.

Actually, a quite good description of the CDS market machinations. And a nice assist by Cathyf.

And yeah, pretty late in the day ('08) to talk about happenings when Larry Summers was Treasury Secretary. Those are my favorite Republican conspiracies.

Has David Corn ever been right about any of these bombshells he launches?

[cathyf]

surely you are not saying that all credit swaps are among foreign entities.

Well the OTCs are all more or less exotic, and they are inherently more risky than exchange-traded instruments. Whenever an exchange-traded instrument is good enough, that's what the customers will choose -- precisely because every exchange-traded instrument is a trade with the exchange, which has the highest credit rating you can get. So whenever a regulated and unregulated instrument are the same or almost the same, the customer will always choose the regulated one -- part of its value is precisely the regulation.

So, yes, in fact the OTCs are almost exclusively instruments which are not practical to regulate. And the most common reason for the impracticality is that the parties are global companies and global groups in global investment banks and the positions are complex mixtures of multiple interest rates, fx rates, stock indices, etc. which have pieces in multiple currencies.

[sophy]

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