Streetwise Professor

October 7, 2009

Strange New Respect?

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 4:55 pm

Exactly 36 minutes after I wrote this:

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Matt Leising at Bloomberg sent me this:

Legislation proposed by U.S. Representative  Barney Frank would weaken an Obama administration  guideline requiring the most common private derivatives to be traded on exchanges or regulated systems.

The Massachusetts Democrat, who heads the House Financial Services Committee, released a  draft bill Oct. 2 that allows for no change in how standardized over-the-counter derivatives are currently traded as long as they are reported to regulators. The Obama plan, released in August, specifies “mandatory trading” on exchanges or swap-execution platforms that would have to be registered with the Commodity Futures Trading Commission or the Securities and Exchange Commission.

“Nothing will really change” the way trades are executed under Frank’s draft proposal, said  Kevin McPartland, a senior analyst in New York at TABB Group, a financial-market research and advisory firm. “There’s no reason, at least that I can see, why anybody would go to an exchange.”

Moreover, Frank’s proposed bill does NOT mandate clearing, although it does empower the CFTC to require clearing of some contracts:

The Commission shall monitor swap activity and transaction data  and by rule or regulation identify specific swap contracts that it determines are required to be cleared  consistent with the public interest, after taking into  account the following factors:

[List omitted.]

I keep having this mental image of Barney Frank falling off a horse on the way to Damascus.

In brief: no clearing mandate, but mandated reporting of derivatives trades to a central data repository.  Just what I’ve been advocating on this blog, and in my writings (such as here).  CFTC has the power to mandate clearing, but that’s a far different thing than a Congressional mandate.

Color me shocked.  Pleased, but shocked.

But not everyone is pleased.  CFTC Chairman Gary Gensler for one is put out by the lack of a clearing mandate:

Gary Gensler, the CFTC chairman, said he was concerned about a provision in the legislation to require securities and futures regulators to determine on a contract-by-contract basis whether a particular swap needed to go through a transparent clearinghouse.

“I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he commented.

Gensler pointed out that an Obama administration proposal for derivatives regulation has a presumption that if any standardized product was accepted for clearing, it and all future iterations of the product must go through a clearinghouse, which is an intermediary between the buyer and seller of the swap.

Gensler and legislators support permitting tailored swaps to continue to trade on the over-the-counter market as long as they meet new reporting, record-keeping and capital requirements.

The CTFC official also took issue with a measure in the Frank proposal that he believes could exempt a broad range of entities from the definition of “major swap participant” and help them avoid regulation.

“The discussion draft, perhaps inadvertently, widened this exception such that the major swap-participant category would exclude any entity entering into a swap for risk-management purposes,” Gensler said. “This could have the unintended consequence of exempting a broad range of entities from the definition of a ‘major swap participant’ and thus exempt such entities from regulatory requirements outlined in the proposal.”

I’d say I feel your pain, Chairman, but I’d be lying.

I am still astounded at this development.  Now if only Geithner, Gensler, Collin Peterson, the Senate Finance and Ag Committees, etc., see the light and experience their own conversions we’d be really getting somewhere.  Hey, a boy can dream, can’t he?  I mean, if Barney Frank comes around to my way of thinking, anything is possible.

Needless to say, I doubt there are many things that Barney Frank and I agree on.  There is still great potential for mischief in a lot pending before his committee.  But, for now I will avoid what my inimitable grandfather called “handing out attaboys one at a time and taking ’em back five at a time.”

For now, I’ll just say: ‘attaboy, Barney.

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  1. I don’t like government. I don’t like Barney Frank; however, I do have a problem here. As far as I can tell, the failure of AIG was, effectively, the failure of a “clearinghouse”. Because they were triple-AAA, they took in initial margin from anyone they traded with (who wasn’t triple-AAA, which was everyone else). Because they were like an initial margin “black hole,” sucking up much of the initial margin on the Street.

    So every time they were counterparty to a contract, they got cash (in the form of initial margin). Guess what? They participated in lots of contracts (even ones that offset). They played with the margin and blew themselves up and nearly took the rest of us with them.

    Doesn’t this show that bilateral margining is fundamentally flawed and we need a third-party to take margin from both counterparties in a transaction? (Clearing would provide the mechanism to do this.) I only ask this question because I only want taxpayers to get screwed for a couple of hundred billion dollars just once in my lifetime.

    Comment by Highgamma — October 7, 2009 @ 5:55 pm

  2. Hi, Highgamma–option trader perhaps? At-the-money? Hopefully not short time to expiration;-)

    Re margin, it is ironic, in a way, that the proximate cause of AIG’s demise was the fact that IT had to meet MTM collateral calls.

    It is also pretty clear that the kind of protection AIG was writing wouldn’t have been clearable then, nor would it be now.

    I wrote a good deal on AIG back in the first three months of the year. My takes were somewhat unconventional. You might want to take a look at these posts. The most complete one is It’s A Wonderful Life: AIG Edition.

    The ProfessorComment by The Professor — October 7, 2009 @ 9:24 pm

  3. I read your post from earlier this year. I only found this blog recently. That post is definitely contrary to the prevailing (and my) beliefs. It is an intriguing argument, though.

    By the way, “highgamma” is a reference to option trading. I traded dispersion (but called it “correlation trading”) when you still had to do everything “by hand”. (No electronic option execution or correlation swaps.) I’m in academia now as well.

    Now to the interesting discussion on AIG and clearing arrangements.

    “Due to its high credit rating, AIG’s counterparties did not demand that it post collateral when it created its positions (though they did include “credit triggers” in the deals allowing them to demand collateral in the event of an AIG downgrade). A CCP would have established minimum initial collateral levels for customers, and implemented a system of margin calls based on changes in mark-to-market values of AIG’s positions as a customer.” (From “It’s a Wonderful Life”)

    Actually bilateral margin is worse than that. Under a standard ISDA, since AIG was triple-AAA and everyone else wasn’t, AIG took in initial margin from its counterparties on every trade. That’s not trading margin-free. That’s worse. Every time they did a trade, cash came rolling in the door in the form of initial margin from its counterparty (unless they were triple-AAA, too, which no one else was).

    One nice feature of trilateral margin arrangements is that firms with weak internal controls eventually notice that money is going out the door (in the form of initial and variation margin). In the case of AIG, the portfolio managers would be able to offset (either partially or fully) variation margin outflows by doing more deals to take in more initial margin. Kind of defeats the whole purpose of variation margin. (There is also a perverse effect of insurance companies looking at initial margin almost as an insurance premium. I’m sure there were some strange discussions at AIG when all of that cash was rolling in initially.)

    My experience is that the whole bilateral margin system became more formal after the LTCM crisis. The Fed wanted to make sure that one of those “big, bad hedge funds” didn’t blow up the financial system. The large banks would take in initial margin and mark everyone to market on a daily basis to make sure hedge funds behaved. It worked. This crisis was definitely not precipitated by a hedge fund blow up.

    But who shall guard the guards? When I asked this question of the head of prime brokerage at Morgan Stanley in 1999, I was told that the regulators were going to keep a close eye on them. I didn’t have to worry about that. Of course, in 2001, Morgan Stanley moved as much of their prime brokerage financing business to London (MSL) as was possible, specifically to avoid that regulatory scrutiny. (They just did what everyone else was doing….)

    AIG was even worse. To this day, I have no idea who really regulated the financial products subsidiary, if anyone, and I’m certain the NY insurance authorities didn’t have the capability to do so.

    But I think the above argument is consistent with a belief that AIG’s positions would have been smaller with a clearinghouse as would have the overall market-wide positions. Pricing would not have gotten as favorable as it did if you eliminated the ability for a counterparty to actually get a check every time it took on risk.

    As one last argument, the oil market went through some incredible gyrations over the past few years. Fortunes were made and lost; however, no major firm went belly up, causing their creditors or taxpayers losses. Why? I think a big contributing factor was that every player in the market had skin in the game in the form of initial margin. I think it would also help in the OTC markets.

    If you’d like to discuss this further please send me an email. I have enjoyed the discussion so far.

    Comment by Highamma — October 8, 2009 @ 12:43 pm

  4. Agree with him or not, Barney Frank is one of the most intelligent and hard-working Congressmen in Washington. As a fellow Bay Stater, I am proud that my fellow Massachusetts citizens continue to elect him term after term.

    Comment by Timothy Post — October 8, 2009 @ 10:38 pm

  5. Look, Professor, I’m simple-minded. And here’s my question to you, and I’ll put it in the form of a proposition to you – while AIG may not have been the sole cause of the financial crisis, clearing house or not, it was a huge contributing factor.

    Why? Well, quite a few years ago, while toiling in the vineyards, I ran into the idea of an “insured” securities investment – these “bonds” are insured by the ACME Triple Doozy Insurance company. What a great idea! Possible gazillion percent returns, and no downside!

    That’s what AIG was doing in this whole scenario. Invest in these mortgages (sold by third parties) – plus, whizzo-presto, here’s some “insurance” to protect you, ON TOP OF the implicit, unspoken guarantee given by FNMA and Freddie Mac that the US Guvmint would also bail you out, even though the mortgages were not guvmint issued securities, which guarantee was sort of not supposed to be given, but there it was, and it was understood without being overtly stated, and there you have it.

    But AIG was not the only one issuing insurance. Apparently, everyone and their brother, sister, cousin and dog were doing it – including even by email. And if you look at the list of “counterparties,” come on – how could these people not have known that this was a sham game?

    I see your statement that what AIG was writing would not have been clearable then or now.

    Pardon my simple-mindedness, but why not? I view all of those credit default swaps as sham transactions, with knowing participation al around on all sides. And I mean all sides.

    In the securities field, I cannot think of a single instance of guaranteed prevention of fraud or abuse. Not one. There are disclosure requirements, and anti-fraud and anti-market manipulation provisions, and a somewhat deterrent effect of enforcement measures.

    How could a clearinghouse for derivatives possibly be any different? I know that is what your article addresses, but I have missed teh answer.

    (And this is off-topic, but I still think it is a travesty, and an outrage, and beyond belief that Barney Frank and all those others spent taxpayer money left and right on this whole mess. And now they want to add to it with Obumacare.)

    Comment by elmer — October 11, 2009 @ 9:35 pm

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