A previous piece (Animal Farm) described the bizarre world of US financial regulation where oversight of Credit Default Swaps (CDS) is in the hands of the US Congress House Committee on Agriculture. At the time, it was suggested that such a parochial committee might not be best placed to oversee some of the most complex financial instruments ever invented.
Sooner than expected, this particular set of Fools on Capitol Hill demonstrated that they have very little grasp of this very tricky problem. On February 12th, the committee passed the wonderfully named 'Derivatives Markets Transparency and Accountability Act of 2009' which it claims to bring 'long overdue transparency and managed risk to the over-the-counter credit derivatives market by using the clearing model that has served the futures markets well for many decades'. Laudable aim, terrible solution!
In theory (I repeat in theory) Credit Default Swaps are excellent tools for reducing risks in 'portfolios' of credit risk.
Assume, for example, that a Swiss bank (such as UBS) has loaned a large sum of money to an American company (say IBM) to build new plants and grow the US economy. However, when looking at its whole portfolio of risks, UBS might find that it is 'overweight' IBM, or the Tech sector, or even the US economy. One solution might be to go to IBM and ask (nicely) that they repay a bit of the loan so that it can be loaned to someone else - but that is not likely to go down well?
Now assume that another Swiss bank (say Credit Suisse) would love to have a piece of IBM, because it is 'underweight' the US tech sector.
With a Credit Default Swap, the two banks can agree, amongst themselves, to 'swap' a bit of the IBM loan. Now since Credit Suisse is (or at least used to be) a better credit risk than IBM, this also frees up capital for even more lending. The magic of diversification.
Now IBM would know nothing about this transaction and since the banks are Swiss the only regulator involved would be the Swiss Banking Commission. No need to bother the House Committee on Agriculture.
Now assume that next time that a Swiss bank is in a bind, it has to look elsewhere for help. Where better to go than the US markets and who better than experts in risk management in the US markets, such as AIG. AIG would love to diversify its risk through a company such as IBM and since they are already regulated by a mish mash of state and federal insurance and securities regulators there is still no need to bother the House Committee on Agriculture.
When could the House Committee on Agriculture become involved? When both parties are US regulated and agree on a standard form of contract that could be settled through a US regulated (or overseas recognized) clearing house. Yeah - that is going to happen! Firms use OTC (Over The Counter) contracts precisely because they don't want to go down that road for all sorts of good reasons.
If they were so good why did Credit Default Swaps bomb?
CDS were such a great idea that everyone wanted to get into the game. Wall street types, such as Lehman Brothers and Bear Stearns, piled in and soon everyone was buying stuff they didn't need, from people they didn't know, for reasons that they were unsure of. That is why the CDS market grew in less than a decade to some $45 Trillion of notional value, well over twice the total value of all of the companies on US stock markets. By 2007, everyone at the CDS Ball was happy, making money and drawing big bonuses. What could go wrong?
In 2008, when some Californians defaulted on their mortgages, midnight struck and Cinderella had to leave the ball, crystal coaches were turned back into pumpkins and footmen back into mice. Smart types such as Lehman found that they had forgotten the first rule of broking; you got to sell stuff as well as buy it. So when they went to their CDS warehouse they found that it was as empty and worthless as a cotton silo after a boll-weevil convention.
Now as protectors of the pumpkin patch, there is at last a role for the Agriculture Committee - they can ban pumpkins being turned into crystal coaches and stop the trade in mice becoming footmen.
It is ludicrous to continue to believe that we can regulate 21st century global financial markets with 19th century parish pump supervisory tools. Regulators have got to get sensible and stop trying to tweak the current systems that have proved convincingly that they don't work. New thinking is needed.
In future, regulation has to be global. The US Congress House Committee on Agriculture has no jurisdiction over Swiss goat herders never mind the banking Gnomes of Zurich.
Regulation also has to be innovative, otherwise supervisors will just be blindsided by the next clever derivative. You cannot regulate a name, such as CDS; it will just keep changing until we run out of three letter acronyms. You have to regulate the financial impact of an instrument, real or potential. This means that supervisors have to understand the overall economic impact of each new derivative. In turn, this implies that regulators have to become smarter and they have to ask firms to fully report the potential impact of their activities rather than guess at the capital that they might need if something horrible were to happen. That hasn't worked!
Meanwhile bank at the ranch, the US Congress House Committee on Agriculture believes that the next Global Financial Crisis will be averted by the mere action of creating a central clearing house (which by the way is a good idea for those firms that want to use such a clearing facility).
The cat is out of the bag, the horse has bolted, the chicken has flown the coop or whatever metaphor is needed to convince the House Committee to leave the stage and shut that stable door behind you as you leave.
As Sir Paul McCartney might have said about the Committee:
"Head in a cloud, the man of a 1000 voices talking perfectly loud
But nobody ever hears him, or the sound he appears to make,
And he never seems to notice".
Like blind mice talking to a deaf post.
