I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful. It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage. How did I learn this? From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd. (I haven’t been able to find a copy online.) The senators state:
As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act. This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.
Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December. A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.
Meanwhile, the California/Western energy crisis had been building throughout 2000. Power prices first spiked in May, 2000. The first blackouts were in June, 2000. San Diego Gas & Electric made allegations of market manipulation in August, 2000. FERC rejected California’s request for a price cap on–wait for it–15 December, 2000. The peak prices observed during the entire crisis occurred in December, 2000.
In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else. Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.
What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature. Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.
Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets). They had nothing to do with the kinds of things addressed in the CFMA.
(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)
So, the senators got off to a very bad start. What about other matters raised in the letter? Well, better, but not much.
The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally. The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.
This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns. The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks. As I’ve written extensively, neither claim is necessarily true, nor even plausible.
The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.” Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.
The Enron failure did not cause a major upset in the energy markets. The implosion of the merchant energy sector occurred some months later. The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002. Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).
But this wasn’t a systemic contagion event. Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons. That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell in value. There was a common shock, and the affected firms fell in common. That implosion would have occurred, clearing or no.
This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention. The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments. That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.
We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.
Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.