I have always held Congress in low regard, but never so low as now. Capitol Hill has become a veritable vortex of stupidity.
Exhibit 1: The laughably mis-characterized “stimulus” bill, which will do nothing of the sort. If a private business engaged in such blatant false advertising, the FTC would shut it down tomorrow. This bill is nothing more than a Trojan Horse stuffed with every political boondoggle conceived over the last decade.
Exhibit 2: “A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market.” The bill forces central clearing of CDSs. As I’ve argued ad nauseum, this is a bad idea. But that’s not the worst of it:
House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the$684 trillion over-the-counter derivatives market to be processed by a clearinghouse.
This requirement that CDS traders “own the underlying bonds” would prevent the credit derivatives market from performing its vital risk transfer function. Note to Congress, and to Rep. Peterson: Hedgers (who own the bonds) want to reduce their exposure to that risk. They do so by buying protection FROM SOMEBODY THAT DOESN”T OWN THE BOND. That is, the bond owner can’t hedge unless he can buy protection, almost always from somebody who doesn’t own the bond. The CDS market effectively transfers risk from the current bondholder to a speculator. This is a transaction between consenting adults that presumably makes both of them better off-or else they wouldn’t do the deal. Put differently, if you want to permit bond holders to reduce their exposure to the risk of that bond’s default, you need to let somebody else increase that exposure.
But this is apparently lost on Rep. Peterson, and the bill’s supporters. They have apparently internalized the view that hedging is good but that speculation is bad. But you can’t have hedging without speculation.
This is especially true in the corporate debt market. In commodities, you have natural long exposures (e.g., oil producers) and natural short exposures (e.g., airlines) who can hedge by trading with one another. Speculators are necessary only to the extent that the hedging demands of the natural longs and natural shorts don’t match completely. In corporate bonds, there is a lot of natural long exposure looking to hedge, but not a significant natural short exposure. Hence, speculators–market participants willing to absorb exposure to default risk–are especially important.
Some reporting I’ve seen about the bill talks about how its supporters denigrate “naked shorting” via the CDS market. Sheesh, just when I’m glad to see Christopher Cox’s taillights fade to black, here are legislators parroting his moronic moralizing about perfectly legitimate–and essential–actions.
Peterson is (as I recall) a former insurance commissioner in Minnesota. Perhaps he would understand this analogy: his bill makes as much sense as one that would allow only firms that own high rise buildings to insure high rise buildings.
This measure is exactly NOT what is needed in the market right now. If anything, our shaky banking system needs better, more robust mechanisms to manage credit risks. It definitely does not need the decapitation of the existing mechanism for managing these risks, as imperfect as that mechanism may be.
I actually wonder why the bill even bothers to mandate creation of a clearinghouse. The provision I’ve just discussed means that there won’t be any trades to clear. So what’s the point of creating a clearinghouse?
Who knows whether this absurd provision will actually become law. Of course it will be distressing–and very costly to the market and to the economy–if it does. But even if it doesn’t, it is bad enough that such a clearly idiotic proposal, predicated in a complete and willful misunderstanding of the role of derivatives markets, has made it this far. It is a testament to a truly frightening combination of ignorance and arrogance that is rife in Congress. So convinced of their own rectitude, and their own ability to control complex markets, they meddle ceaselessly in what they do not understand. They are modern day sorcerer’s apprentices, who wreak havoc in the vain belief that they are doing good.
I say again: I hope Bismarck was right when he said there is a special providence for fools, drunkards, small children, and the United States of America, for we have fools and drunkards (on power) governing America, and imposing crushing burdens on small children–and the children of today’s small children.