Home > derivatives, financial crisis > The Empire Strikes Back

The Empire Strikes Back

June 4, 2009

As nightmarish memories of September 2008 fade, the financial industry is gearing up to fight new regulations. The battle lines are being drawn and became more visible this week.

In May, Treasury Secretary Geithner outlined a plan for regulating the over-the-counter derivatives market. Today (June 4), the Chairman of the Commodity Futures Trading Commission, Gary Gensler, provided a more detailed proposal.  The Gensler proposal basically says that if a financial contract walks and quacks like a standardized OTC derivatives contract, it will have to be cleared through a central clearinghouse, just like a standard exchange-traded contract (think wheat and pork bellies).

The (over-simplified) notion of a clearinghouse is that after A and B trade a contract, the clearinghouse steps into the middle, becoming the buyer to the seller and the seller to the buyer. Derivatives wonks call this process “novation”. Gensler proposes to extend the clearing model of the Chicago Mercantile Exchange to most contracts that are now traded over the counter, i.e. directly dealer-to-dealer or dealer-to-customer.

The banking industry (AKA “The Empire”, in case you were wondering) is not happy and has been preparing for a fight since last Fall. In Monday’s New York Times, Gretchen Morgenson and Don van Natta Jr., in a terrific piece of reporting, discuss the Wall Street lobbying efforts to forestall Geithner’s proposed regulation. On a related front, the Wall Street Journal reveals that banks are fighting efforts to change accounting rules so that off-balance-sheet entities will be put back on balance sheet. Recall that off-balance-sheet structures permitted banks to effectively own risky loans without holding any capital.

I will offer a few brief observations here. I hope to say more in the future:

  1. Once the government mandates central clearing, there will be a powerful implicit commitment to prop up the clearinghouse. Thus, if the Geithner/Gensler proposal goes through, the government will have created a new too-big-to-fail entity, most likely the Chicago Mercantile Exchange clearinghouse. Probably the CME Clearinghouse is already too big to fail, but is this really how we want to fix the problem?
  2. Once the CME (or some other clearinghouse) is too big to fail, it will also be subject to even more intense political pressure than it is now. Farmers are complaining that wheat prices are too volatile and margins are too great? Watch for congress to pressure the CME to change its business practices. (This already happens, by the way.)
  3. The Gensler testimony lays out criteria that “could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms.” Wall Street is expert at constructing new vehicles that skirt rules. You think you’ve seen tweaking? You ain’t seen nothin’.
  4. Wall Street is most profitable when transactions are non-standard and non-transparent, exactly what Gensler is trying to stop. Thus, Congress will be trying to enact rules that destroy multi-million dollar bonuses. Would you bet on regulators or on Wall Street?
  5. There is a wild card in all of this. Congress will hold hearings. Who knows what stories will emerge that might outrage the public and catalyze the movement for serious changes in regulation? The Pecora hearings in 1933 unearthed testimony that induced Congress to create the SEC. Who knows what stories are waiting to be told?

Finally, throughout the public policy discussion, there is a presumption that financial institutions have a fundamental right to privacy. If JP Morgan Chase acquires a $10 billion credit exposure to Goldman, the regulators will in theory know, but the investing public and other banks will not.Why? Shouldn’t investors have a right to know about material credit exposures? If AIG had been forced to reveal the extent and nature of its credit exposures, perhaps the AIG fiasco would never have occurred. (AIG’s counterparties might have balked at dealing with an entity with AIG’s risk profile.) Why do we permit and encourage all-encompassing secrecy? Shouldn’t the presumption of privacy at least be part of the public policy discussion?

To quote Ferdinand Pecora: “Had there been full disclosure of what was being done in furtherance of these schemes, they could not long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were the banker’s stoutest allies.

Some things never change.

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  1. pcp
    July 15, 2009 at 2:00 pm

    Full disclosure is great. I say let’s full disclosure for all these entities involved in bailouts, including the Fed. They are bankers after all and pitch darkness is their stoutest ally.

    The too-big-to-fail is not really a dilemma at all and people who pretend it is are being disingenuous at best and conning the public at worst. If Rome wasn’t too big to fail, then some two chit operation in London, even if it handles multi-billion dollar in bets, is certainly not too big to fail. The best way to avoid too-big-to-fail is stop interfering with the market forces.

    The US government has gotten its hand into this trap, starting with Bear Stearns, and it will drag the body with it in due time.

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