C.M.O. 5.18.2009

Credit Market Overview
May 18, 2009

The only thing possibly shorter than a “New York” minute is a “TV” minute as the latter seems to go by in a handful of seconds and nothing even close to 60.

Having done research on the OTC derivatives regulation proposed in a letter to Congress by Treasury Secretary Tim Geithner for an appearance on CNBC’s Fast Money on Friday and only getting through the first two bullet points, I thought I would give you the benefit of all my hard work.

The four objectives included in the letter are: 1) Preventing activities in those [OTC derivatives] markets from posing risk to the financial system; 2) promoting efficiency and transparency of those markets; 3) preventing market manipulation, fraud and other abuses; 4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

We can lop off the last one right off the bat since the events of the last year and a half have proven that even those parties that were supposed to be sophisticated weren’t that smart at all.

As for the other three let’s go through them one at a time: 1) Preventing activities in those [OTC derivatives] markets from posing risk to the financial system. That OTC derivatives played a part in the collapse of the global financial system is similar only to removing one of the blocks out of a Jenga tower. The need to place blame for the crisis it seems is most vehemently practiced by those whose own implication they are trying to hide.

A point that is conveniently and continuously kept on the down low is that in 1998 then Chair of the CFTC Brooksley Born asked Congress for the power to oversee financial derivatives but was denied such power on the advice of then Fed Chairman Alan Greenspan and Treasury Secretaries Robert Rubin and Larry Summers. Mr. Rubin then went on to Citibank and . . . well; we all know how that turned out.

Pure plain and simple, anything that can be bought or sold exposes the buyer and the seller to risk. Buying or selling enough of it can expose the party to sufficient risk to cause that party insolvency. When everyone does it to an extreme the system itself can become insolvent. There is risk in everything we do. Know it, measure it, control it, but don’t believe you can legislate it away.

2) Promoting efficiency and transparency of those markets. Efficiency and transparency are a good thing and inspire confidence in market participants. Having OTC derivatives cleared through a central counter party should go a long way towards making necessary transaction information readily available.

There is a potential issue here, though, and that it one of multiple clearing entities. The CME and ICE are already operating separate clearing houses. Competition is a great way to find the most efficient way of getting something done. If the goal of clearing OTC derivatives is to have all of the information in one place should something untoward happen then having two or more clearing houses works at directly cross purposes to that goal.

If there is a competition to see who would be the best clearer, that is one thing, having competition between clearing entities is quite different and will only complicate things should another crisis erupt.


3) Preventing market manipulation, fraud and other abuses. There is a push, as part of the proposed regulation, to have OTC derivatives become exchange traded derivatives. Some see this as a way to bring the light of day to a market that is often accused to operating in the dark of night.

Exchanges are very good at trading standardized products. When lots of people are all trading the same thing the markets become deep and liquid. The OTC derivatives markets were not created to avoid standardization but to facilitate the needs of the corporate world. CEO’s and CFO’s are good and running companies and keeping books. They are not necessarily good at figuring out how to transfer the very specific risk they have as a normal part of their business to the market through an exchange traded product.

The sell side firms provide a service to the corporations by performing this translation with highly customized solutions. The needs of the corporations are not going to change just because there was a financial crisis. Patrick M. Parkinson, Deputy Director of the Board of Governors of the Federal Reserve told the Committee of Agriculture this very thing to last November when he said “many CDS’s will continue to be transacted other than through the clearinghouses because of the non-standardized nature of the market”. Such transactions, he said, are “integral to the functioning of today’s financial markets”.

If there is a parallel here I believe it is the Interest Rate Swap market, which by all accounts, dwarfs the CDS market in size but has never garnered similar distain. In the earliest days of the IRS market there was a single Eurodollar contract. Swap levels given to corporate clients were priced to include the risk associated with not having a direct hedge. As the IRS market grew the demand for more back month Eurodollar contracts also grew until there was a contract to represent every calendar quarter from the closest in to a point 10 years away.

Having a good source of price discovery and a liquid hedging vehicle has allowed the IRS market to grow to a size that would not have been achievable without them. A standardized CDS contract would not do away with the OTC market but could actually help it grow.

Profit margins in individual transactions might be narrowed as a result of an exchange traded contract but if the IRS market is any indication, the size of the pie should grow such that even a smaller slice will mean more to eat.

Lastly, there is the politicization of the OTC derivatives issue. Congress is hell bent on finding a straw dog for the financial crisis that they themselves helped create by allowing FNM and FRE to buy all those mortgages that were very much less than prime. FNM’s $0.78 share price and its 2Q09 loss of $23.17BN and necessary infusion of an additional $19BN of taxpayer money stands as testament to that.

In Congress’ efforts to find something to hang in effigy the risk becomes that excessively tight regulation will hamper transaction flow. Capital is like water, it will flow along the path of least resistance. If Congress learns anything from its forays on Wall St. let’s hope they learn that lesson first.


Enjoy the week.

Jim Delaney