High & Low Finance Derivative Profits for Dealers Lead To Complexity & Secrecy

High & Low Finance Derivative Profits for Dealers Lead To Complexity & Secrecy
Date: Friday, June 26, 2009, 12:02 PM

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http://www.nytimes.com/2009/06/26/business/26norris.html?hp=&pagewanted=all

By FLOYD NORRIS
Published: June 25, 2009

In the world of derivatives, profits for the dealers come from complexity and secrecy.

As a new regulatory system for derivatives is shaped on Capitol Hill, the banks will try to preserve as much of both as they can. To the extent they succeed, it will be the customers, and the financial system, that are at risk. Already the banks seem to be winning one important battle, that of explaining why derivatives exist.

In Congressional testimony this week, Mary Schapiro, the chairman of the Securities and Exchange Commission, and Gary Gensler, the chairman of the Commodity Futures Trading Commission, laid out the case for extensive regulation. But they also had kind words for the products. Derivatives, Ms. Schapiro said, allow parties to hedge and manage risk, which itself can promote capital formation.

For some derivatives, that is true. But the generalization is not always accurate, and there needs to be consideration as to whether some derivatives deserve to exist at all.

Simply put,said Richard Bookstaber, one of the pioneers of financial engineering on Wall Street, “derivatives are the weapon of choice for gaming the system."
Mr. Bookstaber wrote one of the best books about the causes of the financial crisis, "A Demon of Our Own Design," and did so before the crisis erupted. This month, his testimony to a Senate subcommittee provided a stark lesson in the uses to which derivatives have been put.

Derivatives,he testified, provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored.They let institutions dodge taxes and accounting rules.

Viewed in an uncharitable light,he added, derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market.
And they were side bets that could destabilize the markets. Had American International Group been gambling in regulated markets, it would have been required to put up collateral when prices began to go against it. Instead, it was able to ignore the problem until its own collapse and perhaps that of the financial system was imminent.

Even when derivatives do allow financial risks to be transferred, that is not always a good thing. John Kay, a leading Scottish economist, noted recently that he used to teach along with most other economics professors, that derivatives allowed risks to be transferred to those better able to bear them. But, he added, experience had shown that to be wrong. Now, he said, he teaches that derivatives allow risk to be shifted from those who understand it a little to those who do not understand it at all. That is not a bad description of how the risks of bad mortgage loans were transferred from those who made the loans to those who bought troubled collateralized debt obligations.We would be much better off as a society if that particular transfer of risk had been regulated, or even prevented. At a minimum, there should have been a lot more disclosure about just what was going on.

The Obama administrations outline for bringing the derivative markets under regulation addresses all the important issues. But the details, to be worked out in legislation and later in regulations, will be critical. Wall Street will try to keep as much of the market as possible from moving to exchanges, where prices would be transparent and those taking risks would have to put up collateral immediately when prices moved against them.

Instead, the derivatives industry has already started a public relations campaign claiming that it is helping businesses, particularly small ones, hedge their risks by devising custom derivatives and not requiring the customers to post liquid assets when they begin to lose money. They argue that forcing companies to put up cash when they gamble would take money away from the companies’ productive investments, and thus damage the economy.

It would also mean that those gambles could not destroy the companies making them. All too often, Wall Street has come up with complicated vehicles with little upfront costs but huge potential risks, and made lots of money on them from customers who are in no position to assess the fair value of the derivative or to bear the losses if the risks materialize.

The Obama administration has embraced the principle that complicated, illiquid derivatives should require higher margins from customers. If there is to be effective regulation, it is critical that the administration prevail on that issue.
It is also important that as much derivative trading as possible be pushed into standardized, exchange-traded contracts. The customers should be demanding that, simply because it would reduce their transaction costs, but many have been persuaded by the claim that customized products serve their needs better.
And sometimes the customers like the complexity. It makes it easier to hide the risks and leverage they are taking, as well as the noneconomic objectives such as evading regulations that they may prefer not be noticed by authorities.

Given the overlaps of the derivatives, commodities and securities markets, nearly everyone who has studied the issue thinks it would make sense to merge the S.E.C. and the C.F.T.C. But the agencies are overseen by differing Congressional committees that wish to retain their influence, and the campaign contributions that influence attracts. The administration evidently decided that was not a fight worth making.
Instead, Ms. Schapiro and Mr. Gensler hammered out a general agreement on which agency should regulate which product. Its not perfect, but it could work, particularly if the regulators hire people, such as Mr. Bookstaber, who understand how the games are played.

There could even be an advantage for the public in multiple regulators. Back in the Clinton administration, when Wall Street was persuading Congress to allow derivatives to escape nearly all oversight, the chairman of the C.F.T.C., Brooksley Born, sounded the warning about the risks of that course. She lost. Had she prevailed, the financial disaster might not have happened.

In the future, it is at least possible that if one agency is effectively taken over by those it regulates, the other might be able to protest and get public attention.
Despite the clear evidence that Warren Buffett was right when he called derivatives â financial weapons of mass destruction. There has been little talk of giving regulators authority to ban some derivatives.

Perhaps, however, the Obama administration has that idea up its sleeve. Its white paper on financial regulation calls for authority to prevent market manipulation, fraud, and other market abuses.My efforts to find out just what is included in that last catch-all category were not successful.

When the derivatives industry was persuading Washington to let it alone, one argument was that any American rules would just drive business overseas, hurting American competitiveness. That argument will be heard again, and makes it necessary that there be international regulatory cooperation. But the fact that some market allows something is not enough to prove everyone should allow it.

For far too long, Wall Street was allowed to play as it wished. It is a major understatement to say that privilege was abused. The details of derivatives regulation adopted this year will go a long way to determining whether and when the next financial crisis will engulf the world.

Floyd Norris comments on finance and economics in his blog at nytimes.com/norris, and you can go there now by clicking on the title above.