Streetwise Professor

November 12, 2015

Big Sister on the Warpath Against Commodity Derivatives

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 3:27 pm

Elizabeth Warren’s panties were in a bunch the other night because of an ad that portrayed her as a “Commie dictator” (her description). (Liz’s panties always seem to be in a bunch, but they were bunchier than usual on Tuesday.) The ad, which blasts Warren’s anti-Constitutional monstrosity, the Consumer Financial Protection Bureau is actually somewhat amusing. Warren’s image appears in the background on a Big Brother-ish–or would that be Big Sister-ish?–banner.

I agree with Warren. She is not a  Commie dictator. She is a wannabe Commie dictator.

Her anti-market efforts are not limited to birthing and defending the CFPB. She is also a virulent critic of derivatives, especially when banks trade them. Pre-commercial, her ire this week was focused on the repeal of the swaps pushout rule, the brainchild (and I use that term very loosely) of fortunately ex-Senator Blanch Lincoln (D-for-dim, Arkansas). Warren fulminated that as a result of the repeal, banks were able to keep $10 trillion notional in particularly risky swaps in their deposit-taking units, rather than spinning them off into separately capitalized subsidiaries that cannot benefit from deposit insurance.

This rule was targeted at swaps that were deemed especially risky, including most notably, commodity swaps. But commodity swaps, and many equity derivatives, are not especially risky. Risk depends on whether the positions are hedged or hedgeable, the creditworthiness of the counterparty, and the credit support (e.g., collateral) in the transactions. And notional principle is certainly not a measure of how much risk is in a derivatives book. Therefore, putting commodity swaps, equity swaps, etc., in a ghetto does not make economic sense. There is no reliable mapping between the underlying of a derivative and the risk it creates.

Furthermore, risk has to be evaluated on a portfolio basis. Segmenting derivatives books can reduce diversification benefits, and crucially, breaks netting sets. Breaking netting sets tends to increase counterparty risk, or require more costly collateral to keep counterparty risk the same. (As I’ve written many times, the systemic effects of netting and collateral are ambiguous because of their main effect is redistributive. But if you are concerned about the counterparty risks that banks face, you should prefer more netting to less.)

Frankendodd is chock-full o’ stupid and dangerous, but the swaps push out was in the running for the title of dumbest and most dangerous. It makes no economic sense as a way of achieving the purported purpose of reducing the risks that banks pose to taxpayers. But Warren and other progressives have made it a litmus test for determining which side you are on, that of the angels, or the banksters? This is a false choice.

But expect Big Sister Liz to remain on the warpath against derivatives. Which is exactly why the 1984-esque portrayal of her in that commercial is spot on.


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  1. You Are Correct Sir!

    Time to blow up the veil that she hides behind.

    Comment by pointsnfigures — November 13, 2015 @ 9:58 am

  2. Prof – love the blog. Stumbled upon it. Learning a ton of new stuff – keep up the great work!


    Comment by Student — November 13, 2015 @ 1:14 pm

  3. @streetwiseprof

    I think you are not quite spot on with your criticism here. Warren is not saying that all portfolios with derivative instruments are risky. She is saying that to create a truly risky portfolio, derivatives are one of the easiest ways to go. Rather than having government agencies evaluate the riskiness of the portfolio, she wants to force these potentially risky instruments into entities that do not benefit from government insurance. As far as the netting goes, I don’t think she is saying the counterparties should be left without access to the collateral. Any assets that are netted would have to be transferred along with the derivative instruments (plus possibly additional collateral) to satisfy the counterparties. Yes, there will still be a break between the assets that remain in the insured entity and the entity that owns the swaps so the counterparty may consider the new entity to be less creditworthy, but that is not the same thing as completely breaking the netting. The idea is that decreased costs to entering into these contracts should not come from the fact that the counterparty can rely on the FDIC and the discount window in the event of a default.

    The real problem with the Swaps Pushout Rule was articulated at the time by Ben Bernanke, Paul Volker, Mary Shapiro, and Sheila Bair. Was AIG FDIC insured? Was General Motors? Was General Electric? No, no, and no – but they all got bailed out. By pushing the swaps outside of the FDIC insured entity you are not reducing any risk even if these portfolios were particularly risky. Furthermore, you leave open the possibility that these instruments will be owned by entities organized in Grand Cayman or Turks and Caicos that no US government agency could regulate if the finance sector went south. Thus the Swaps Pushout Rule might actually increase systemic risk even if it lowers the risk to particular FDIC insured banks.

    Comment by Ben — November 25, 2015 @ 9:37 am

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