Sunday, April 18, 2010

The Derivatives Shell Game

The Wall Street Journalreports that your Congress is considering measures that would "improve transparency and reduce risk in the derivatives market." It is not surprising that there are obstacles to such reform. The Republicans oppose anything that might make the Democrats look good. The Big Banks oppose anything that might intrude upon their Privatize The Gains, Socialize The Losses (PGSL) business model and thus restrict their ability to take crazy risks to make obscene amounts of money.

Senate Democrats, resisting a last-ditch lobbying push from big Wall Street firms, are moving toward a sweeping revamp of financial regulation that would squeeze banks' lucrative derivatives-trading business. Wall Street giants Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and Morgan Stanley had been pressing hard in recent days to dilute provisions of the bill that would change the rules for derivatives trading...

Their main concern: Trading on exchanges or via clearinghouses could reveal more details about the pricing and structure of the deals, potentially benefiting rivals and clients, and in the process eating into profits. Banks have also argued that any requirements that their customers use standardized derivative products, instead of individually customized deals, would limit customers' flexibility.

Spokesmen for Morgan Stanley and Goldman Sachs declined to comment on lobbying efforts...

The Derivatives Shell Game

Let's briefly review the way things work now. I provided some details a few months ago in Crisis = Opportunity? Banks or other institutions like A.I.G. can design and trade customized derivatives over the counter (OTC), which means that no one but the counter-parties know what the contracts say. If Goldman Sachs, also known as the Giant Vampire Squid, having played both sides of the fence, is now betting that the housing market will fail, they don't want anyone to know that for the reasons specified above: trading on exchanges or via clearinghouses could reveal more details about the pricing and structure of the deals, potentially benefiting rivals and clients, and in the process eating into profits.

Within the PGSL model, the size of these bets and counter-party risk of default don't matter because the government can be counted on to bail out the counter-parties should these contracts blow up. This is exactly what happened in 2008.

Using clearinghouses can reduce risk to the overall financial system. Because they are usually backed by a group of Wall Street firms, if any one firm were to fail, the clearinghouse would remain able to make good its promises.

Derivatives woes played a significant role in the failure of some financial firms, including American International Group Inc., which provided guarantees it couldn't meet when the financial system unraveled in 2008.

In a more transparent system involving an exchange (clearinghouse), everyone will know who is betting on what, with who, and how much. Awkward questions might arise. Like why is the Giant Squid betting massive amounts of money that the sub-prime CDOs they wrote are junk?Or why is A.I.G. "insuring" this junk by issuing credit default swaps to the Squid?Or does A.I.G. have adequate capital on hand to pay off if they lose the bets the Squid set them up to lose?

The banks do not want anybody asking embarrassing questions about how they make huge amounts of money on derivatives trades.

The Derivatives Shell Game

In the past few days, officials from Goldman's New York headquarters came to Washington to meet with the Agriculture Committee staff. A prominent J.P. Morgan official, Blythe Masters, a frequent contributor to Democrat campaigns, has both testified in public and met privately with the panel's aides. Earlier this year, J.P. Morgan hosted Sen. Lincoln in New York where she met with senior executives. The bank's political action committee contributed $5,500 on Jan. 14 to her reelection campaign.

Trading in derivatives is concentrated in five large Wall Street banks—J.P. Morgan, Goldman, Morgan Stanley, Bank of America Corp. and Citigroup, Inc. The business produced revenues of about $20 billion last year, according to Comptroller of the Currency and industry estimates.

Let me tell you how this is going to go.

There will be numerous stories in the mainstream press about the political wrangling and bank lobbying (like this one from the Washington Post or this one from the New York Times).These stories will appear with greater frequency up to the cut-off point, which is a week or so before Memorial Day Weekend, after which our elected representatives will disperse to apply the bribes they have received to campaign for re-election.As the deadline nears, the Huffington Post and others will write more and more stories about loopholes in the legislation that allow banks to escape the onerous restrictions on their derivatives trading. These loopholes will be large enough to drive a truck through.Things will come to a head in the week before Memorial Day Weekend as the Senate gets ready to vote on the bill. No one in Congress will actually know what is in the bill, which is 17,000 pages long. Large sections of the bill will contain text taken verbatim from bank lobbyists.The reform legislation will or will not pass, depending on what backroom deals are cut, but you can be certain that no bill will pass that effectively regulates all derivatives trading by Wall Street Banks.In the days & weeks after Congress goes home, more and more people will realize that the legislation, if it did pass, was merely cosmetic in most (if not all) respects.Paul Krugman (among others) will write a column (or columns) expressing his disappointment with the  legislation.

That's how this Derivatives Shell Game works.

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