A Meme is Born
Today’s musical selection is Queen’s I Go Crazy. (Some may dispute the verb, or the tense thereof.) What is making me go crazy? The continuing stream of conclusory assertions that someway, somehow, OTC derivatives are at the root of the current financial crisis, and that some past opportunity to regulate these monsters was missed, thereby paving the way for our current difficulties.
This WaPo article is a classic in the genre. Inasmuch as I am quoted in it, perhaps I seem an ingrate to criticize, but criticize I must–although it is better than most. In this narrative, ardent free marketers and patriarchial figures Alan Greenspan, Arthur Levitt, Robert Rubin, and Larry Summers crush the Quixotic crusade of valiant CFTC chair Brooksley Borne to regulate OTC derivatives. If fair Brooksley’s advice had been taken, the article suggests, what went wrong wouldn’t have gone wrong.
That is, to say the least, a very debatable proposition. One thing worth noting is that the focus at the time was interest rate swaps, instruments that have played no role in the collapse of any financial institution. Credit derivatives were in their infancy at the time discussed in the article. Indeed, they were barely a gleam in their inventors’ eyes.
More importantly, although Born warned of the systemic risk posed by OTC derivatives, discussion of how any specific regulation she proposed would have affected current events is completely absent. Nor was Born herself particularly specific at the time.
The article discusses clearing, but importantly misses a key point. The Commodity Exchange Act (CEA) requires contracts for future delivery to be traded on a designated contract market, i.e., and exchange regulated by the government. The concern at the time was that the legal status of OTC swaps ambiguous given this language. Were swaps futures? If they were, any swap not traded on an exchange would potentially be legally unenforceable. This was a major, major concern. In response to this, during this time period the CFTC proposed a set of criteria to distinguish futures–that had to be traded on exchanges–from non-futures, that were exempt from the contract market provision of the CEA. One of the criteria that would have made something a future was centralized clearing. That is, a centrally cleared product was more likely to be considered a future than one that was not centrally cleared.
Thus, if anything, CFTC policy ideas at the time militated AGAINST moving to central clearing of OTC instruments. In essence, the Born-era CFTC approach tied the means of execution (on an exchange) to the means of sharing credit risk (central clearing.) The Commodity Futures Modernization Act (CFMA) essentially avoided this pernicious bundling constraint, and thereby made it more likely that OTC clearing would develop.
There is no reason to force all trading into a particular model, e.g., to force all transactions to occur on exchanges. Many important markets are dealer markets–the Treasury market being a prime example. A CEA-type link between trading mechanism (on exchange) and performance risk sharing mechanism (clearing) creates an unnecessary constraint that raises costs. It requires a one size fits all approach despite the fact that a diversity of trading and risk sharing mechanisms satisfying heterogeneous and diverse needs is likely to be efficient.
The article also denigrates the elimination from the CFMA of a provision calling for federal oversight of a clearinghouse. But, as the article notes, the OTC clearing idea “sat dormant.” If it wasn’t adopted with less onerous regulations, is it reasonable to conclude the industry would have started one if more strict regulations were in place?
The reasons for the dormancy of OTC clearing are important to understand, and not completely understood. I have a slew of clearing-related posts coming, so I will defer fuller discussion until then. For now, suffice it to say that Brooksley Born’s defeat at the hands of the patriarchy had nothing to do with it. As I already noted, the Born ultimatum approach would have actually impeded the development of clearing. It should also be noted that the article’s narrative is contradictory; the article specifically states that Treasury pushed for the idea of an OTC clearinghouse even though Treasury Secretary Rubin is portrayed as one of Born’s antagonists.
Moreover, the article states that the failure of AIG was attributable to its large losses in credit derivatives, and implies that if credit derivatives had been better regulated then (a) AIG’s failure might have been avoided, and (b) the financial crisis would have not been as bad as it is. The latter proposition is the important one, and the basis for it is completely lacking in the article, and in most discussions of the issue.
Ultimately, AIG’s failure is attributable to the fact that it insured against losses on mortgage securities, and these mortgage securities plummeted in value. It is exactly analogous to an insurance company that insured against earthquakes, only to be bankrupted when a trembler of unprecedented power occurred.
That is, in the first instance AIG’s losses on credit derivatives were a symptom of, rather than a cause of, the financial tremors. And as I have written before, it is plausible that (a) AIG was the efficient bearer of this risk, and (b) as a result, the same tremor would have wreaked even greater havoc on less-well capitalized institutions had they not purchased insurance from AIG. No insurance company should be so well capitalized that the probability of default is zero. Thus, the fact that an insurance company failed does NOT imply that constraints on its issuance of insurance would have been welfare improving. In fact, the opposite conclusion is far more likely to be true; constraining or eliminating even incomplete insurance would have almost certainly been inefficient.
To make OTC credit derivatives the villain of the piece requires a more complex argument. One would have to argue that the existence of insurance for mortgage derivatives contributed to the proliferation of subprime debt, and tranched securities created atop it, and to the housing bubble. For these mortgage/real estate factors are at the root of the current difficulties. This causal link is inherently indirect, and very hard (and perhaps impossible) to prove. Moreover, any contribution of credit derivatives is almost certainly of second or third order as compared to the direct causes–loose monetary policy, political encouragement and subsidization (via Freddie and Fannie) of subprime lending, agency problems, rating agency failures, etc.–that fed the housing bubble and the proliferation of subprime debt.
I again reiterate that one needs to be specific as to the content of regulations before passing judgment on their likely effects. In particular, it is very difficult to demonstrate how most regulatory proposals, which frequently focus on various fraud, disclosure, trading mechanism, and manipulation-related issues, mitigate systemic risks.
Furthermore, I would suggest that any attempts to regulate instruments per se are almost inevitably doomed to failure. Regulate one instrument, and in a trice financial engineers will figure out a workaround. This is almost certainly a wealth-reducing arms race. (Were I speaking completely self-interestedly, I would advocate such regulatory efforts, for it would increase the derived demand for my services.) A functional regulatory approach is preferable under these circumstances, but the basic distinction between functional regulation and regulation of particular instruments has been completely overlooked in most of the public debate.
In sum, I go crazy because the public treatment of regulatory issues surrounding derivatives is largely built on myths, incomplete history, and a failure to understand the basic vulnerabilities of any regulatory system. A Reuter’s article aptly states that credit derivatives are “vilified as a major contributor to the current financial crisis.” This is true, but the argument behind the vilification is largely–and arguably completely–nothing but an assertion, repeated over and over again, with little supporting argument and less supporting evidence. This is the perfect hothouse environment in which to grow bad policies and bad regulations that will have serious, adverse unintended consequences down the line.
What is needed is a sober appraisal of the costs and benefits of specific financial innovations, and proposals to regulate their use and development. What we have instead is knee-jerk reactions based on bad analysis. Virtually everyone is calling for more regulation, details to follow. Having seen how regulation often works, I reply: Be damned careful what you ask for.
