Streetwise Professor

September 25, 2008

Regulate This Too

Filed under: Derivatives,Economics,Politics — The Professor @ 7:37 am

From the solons of Time’s Curious Capitalist blog, an assertion that Chris Cox is “An American Hero” because he opposed the Commodity Futures Modernization Act of 2000. Apparently, blogger Justin Fox believes that OTC derivatives are somehow responsible for the current financial mess. Just how, exactly, Justin doesn’t feel obliged to tell us. The logic seems to be: (a) The Act was passed in 2000 in a hurry in the dark of night, (b) OTC derivatives are waaayyy complicated and unregulated and really scary financial instruments, (c) we’re experiencing a financial crisis 8 years after the Act was passed, and (d) Phil Gramm had his hand in it. Or something. There isn’t even a semblance of an attempt to make a connection between a change (a clarification really) of the rules for OTC derivatives and the current financial crisis.

That’s probably a smart move on Justin’s part, because it is very hard to see any such connection. The main problems with the financial system stem from exposure to real estate markets that financial institutions incurred due to their purchase of mortgage SECURITIES regulated by the SEC. This includes massive purchases by securities firms regulated by the SEC.   Moreover, the ratings firms that provided credit ratings for these securities are already SEC regulated.

The closest immediate connections of big, bad “unregulated” OTC derivatives to the current crisis are (a) the collapse of AIG, due to its huge net position in credit derivatives tied to mortgage securities, and (b) the systemic risks posed by the interconnections of parties who engaged in derivatives transactions.

Even here, though, the case is not altogether clear. Consider AIG (and monoline insurers that also sold protection on various credit risky instruments.) AIG was a big seller of protection against the decline in the values of mortgage securities. But the derivatives market is a zero sum game. If AIG lost zillions, somebody made zillions. Who? Some might have been hedge funds or others taking a speculative position opposite AIG. Others, however, were purchasing protection as a hedge of positions held in their portfolios. Absent AIG’s sale of protection to them, they would have suffered unhedged losses on their underlying positions in the securities. Absent this protection, some–perhaps many of them–would have gone bust. AIG’s failure is big, ugly–and noticeable. The failures avoided could well have been bigger (because the protection buyers were even less well-capitalized than AIG, a difference which created the gains from the risk transfer in the first place) and uglier, but as they didn’t happen, they aren’t noticeable.

Put differently, the existence of derivatives affected the distribution of wealth resulting from changes in the prices of the underlying securities. It did not affect total wealth–somebody’s loss was somebody else’s gain, penny for penny. The whole motivation for derivatives is that changes in the distribution of wealth contingent on the state of the world leads to a more efficient allocation of risk, making the transacting parties better off ex ante. AIG put its capital at risk insuring (it is an insurance company, after all) contingencies that others didn’t want to bear. In the event, AIG suffered huge losses, but in many cases, absent the existence of a credit insurance market its losses would have been borne by firms less-well capitalized to bear them.

Earthquakes and hurricanes put some insurance companies out of business because the resulting claims exceed their capital. Does that mean we should ban insurance against such natural disasters? If we did, you bet–no insurance company would fail! But millions of homeowners would bear greater losses. It is better to have an insurance market where insurers sometimes fail, than to have no insurance market at all. The fact that insurance companies fail just means that risks are not fully insured. The policyholders of the failed company don’t get all their claims covered to the extent that they are contractually entitled. But they usually get some coverage. This leads to a better allocation of risk than would occur with no insurance market at all.

The real root of the current crisis is securities that have plummeted in value. This decline in value represents a decline in wealth, not, as in the case of derivatives, a zero sum change in the allocation of wealth. The CFMA had nothing whatsoever to do with the plunge in the value of these instruments, and the concomitant loss of wealth. Indeed, there is a strong case to be made that the liberalization of the OTC derivatives market and the subsequent growth of the credit derivatives market actually mitigated the adverse impact of this decline in the value of these securities.

For his part, however, Chris Cox stills sees the derivatives boogey man under his bed. To wit, from Market Movers, Cox’s testimony on the need to regulate credit derivatives:

There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.

This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.
Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can “naked short” the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern. As the Congress considers fundamental reform of the financial system, I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets.

In other words, show Chris Cox a derivative, and he just sees an evil manipulative tool. (Or maybe he just has some sort of Puritanical hang up with nakedness. One can almost sense the frisson every time he utters the words “naked short.”)

I have already taken Cox to task for his dim understanding of the economic functions of financial markets, but since he won’t go away, I guess I shall have to taunt him a second time. First, shorting is not per se bad. It can make markets more efficient, and indeed, markets where shorting is not possible are more vulnerable to bubbles than those where it is. We WANT markets to reflect bad news too–we want prices that reflect all information, not just happy talk. Second, buying CDSs is often a risk reducing transaction–those long the underlying credit hedge their exposure (as discussed above). Third, although it is possible that someone long a CDS would profit if the price of the underlying instrument declines, or experiences a credit event, and thus may be tempted to do something to cause such a price decline or credit event, if Chris Cox has a particular example in mind, he should share it with the class. Better yet, he should bring an enforcement action. Even if the CDS is not regulated itself, the underlying security would be subject to SEC regulation, and any attempt to manipulate its price would be actionable. (This also shows that the “loophole” is a figment of Cox’s fervid imagination. A manipulation than enhances the profit of the CDS position would necessarily distort the price of the underlying security. This would involve some sort of fraud or manipulation that would fall under SEC jurisdiction. I should also note that creation of large long CDS positions is actually more likely to increase the risk of a squeeze that artificially inflates debt prices during credit events. Well, go figure–I said that 2.5 years ago.)

Chris Cox, American hero? Hardly. The title to this Green Day CD fits far better.

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