Streetwise Professor

March 16, 2010

It Was a Dark and Stormy Night

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 6:06 pm

In an uncharacteristically dyspeptic opinion piece on his newsletter, John Lothian concludes that CFTC Chairman Gary Gensler has his eye on something more than Chairmanship of what has long been an also ran among Federal agencies:

There has been talk in Washington, Chicago and in the media that Gary Gensler has ambitions to become the next Treasury Secretary should Tim Geithner’s reputation continue to take a beating and be force out.  It has been written, said and whispered that he is positioning himself for this promotion.  After seeing him in action at Boca, I tend to agree with this assessment.  We have had short-timer CFTC Chairmen before, with ambitions for greater jobs.  One only has to think of Reuben Jeffrey, who was mailing it in as CFTC Chair shortly after being named to the position, or so it seemed at the time.

To which I say: well, yeah.  When asked by a reporter for my appraisal of the CFTC commissioners last August, I wrote that it was pretty clear that Gensler had his eye on Treasury.  It’s only become clearer since then.

And in his campaign, Gensler is willing to say anything–anything–even if it is misleading, or untrue.  Consider what he said in an interview with Jeremy Grant at the FT (available here, for now, anyways): “The dealers collectively nearly burned down the financial system . . . . We know that.”

It is no doubt true that firms that are dealers, namely Lehman and Bear, failed, thereby shaking the financial system to its foundations.  We know that other firms that serve as dealers dealt with AIG (which was not, as commonly understood, a dealer), and that these dealings played some role in AIG’s bailout (exactly what role none of the principals involved will state forthrightly or consistently).  We know that other firms that serve as dealers, such as Citi and BofA and Merrill, were in desperate financial trouble.

But it is misleading, and a non sequitur, to assert that these events justify the kinds of regulation that Gensler is flogging endlessly in purple prose.  For once, I would like Gensler to state specifically what these various dealers did, qua dealers, that put the financial system at risk, and how the proposed regulations would address this behavior.

Again: read the Valukas report on Lehman.  The catastrophic investments that Lehman made involved pretty much everything but its OTC derivatives business (which was in the black to the tune of $21 billion).  Residential real estate, commercial estate, CDOs, private equity, leveraged loans, you name it.  Merrill and Citi and BofA were also torpedoed not by their activities as OTC dealers, but as underwriters of and investors in CDOs and other real estate related investments.

It is a bait-and-switch to say that “dealers” cratered the financial system to justify regulation of dealer activities.  Doing so suggests that it was the OTC dealing activities that were the root of the problem, when they clearly were not.

But, you might argue: OTC derivatives dealing creates interconnections between firms that can communicate financial contagion.  It is definitely true that the events make plain something I’ve flogged myself for well over a year: namely, that balance sheet risk arising from other investments and activities is an important determinant of the default risks posed by any dealer firm.  But it is just this kind of risk that clearinghouses do not and cannot price, nor effectively control.  And it is just this kind of risk that can be spread to big financial firms via their interconnection through a clearinghouse.  Clearing does not make interconnection go away: it reconfigures the interconnections, and does so in ways that can be riskier, not safer.

So, balance sheet risk is arguably a problem, but clearing is quite definitely not the solution; exchange trading and post-trade price transparency are even less relevant to this problem.  Indeed, it can make the balance sheet risk problem worse, and will do so IMHO.

It is, in short, perfectly consistent to excoriate the banks for what they did (and sadly, for what some continue to do) while opposing the proposed regulations of OTC derivatives.  These banks are big, complex, and engage in a wide variety of activities.  Some of the risks that banks ran proved ruinous, or nearly so.  But the OTC  dealing activities are not high on the list of those risks, if they are there at all.  But that doesn’t stop Jeremiah (or is it Ahab?) Gensler.

And a shout out to Stacy-Marie Ishmael at FTAlphaville who joins me in mocking (though she is more gentle in her mocking than me) Gensler’s fondness for metaphors over-the-top, mixed, and just plain wrong*.  But literary merit–not to mention fairness or accuracy–is of little moment when there is a political battle to be fought–or a cabinet post to be won.

* I am still chuckling over the Mrs. O’Leary’s cow Genslerism.  It is the perfect metaphor for him to use.  Like much of what Gensler peddles, the story of Mrs. O’Leary’s cow was a complete myth.

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