Archive for December 12th, 2010
Derivatives. Americans had never heard of this word until 2008. Now it seems there isn’t a day gone by where we don’t hear it mentioned somewhere. But do Americans really understand what derivatives are? Clearly, there is a pretty negative connotation assosciated with the word, but why? It isn’t that the concept of off-setting or mitigating risk is bad, which is what derivatives were originally designed to do, it is that they have become completely opaque. If one cannot see what is behind door #1, exactly how does one know what door #1 is worth? You don’t. And that is precisely what is wrong with derivatives.
On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.
PROTECTING THE CUSTOMER Daniel Singer runs a heating oil company in Elmsford, N.Y., and is a derivatives customer. In order to offer homeowners fixed-rate oil plans, he buys derivatives contracts. But since the trading system is not transparent, he can’t tell whether the prices he gets are fair or not.
The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.
In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.
The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.
Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.
This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.
But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.
“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.
Derivatives shift risk from one party to another, and they offer many benefits, like enabling Mr. Singer to sell his fixed plans without having to bear all the risk that oil prices could suddenly rise. Derivatives are also big business on Wall Street. Banks collect many billions of dollars annually in undisclosed fees associated with these instruments — an amount that almost certainly would be lower if there were more competition and transparent prices.
Just how much derivatives trading costs ordinary Americans is uncertain. The size and reach of this market has grown rapidly over the past two decades. Pension funds today use derivatives to hedge investments. States and cities use them to try to hold down borrowing costs. Airlines use them to secure steady fuel prices. Food companies use them to lock in prices of commodities like wheat or beef.
The marketplace as it functions now “adds up to higher costs to all Americans,” said Gary Gensler, the chairman of the Commodity Futures Trading Commission, which regulates most derivatives. More oversight of the banks in this market is needed, he said.
But big banks influence the rules governing derivatives through a variety of industry groups. The banks’ latest point of influence are clearinghouses like ICE Trust, which holds the monthly meetings with the nine bankers in New York.
Under the Dodd-Frank financial overhaul, many derivatives will be traded via such clearinghouses. Mr. Gensler wants to lessen banks’ control over these new institutions. But Republican lawmakers, many of whom received large campaign contributions from bankers who want to influence how the derivatives rules are written, say they plan to push back against much of the coming reform. On Thursday, the commission canceled a vote over a proposal to make prices more transparent, raising speculation that Mr. Gensler did not have enough support from his fellow commissioners.
The Department of Justice is looking into derivatives, too. The department’s antitrust unit is actively investigating “the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,” according to a department spokeswoman.
A COST TO EVERYONE Gary Gensler of the Commodity Futures Trading Commission says the current system “adds up to higher costs to all Americans.”
Indeed, the derivatives market today reminds some experts of the Nasdaq stock market in the 1990s. Back then, the Justice Department discovered that Nasdaq market makers were secretly colluding to protect their own profits. Following that scandal, reforms and electronic trading systems cut Nasdaq stock trading costs to 1/20th of their former level — an enormous savings for investors.
“When you limit participation in the governance of an entity to a few like-minded institutions or individuals who have an interest in keeping competitors out, you have the potential for bad things to happen. It’s antitrust 101,” said Robert E. Litan, who helped oversee the Justice Department’s Nasdaq investigation as deputy assistant attorney general and is now a fellow at the Kauffman Foundation. “The history of derivatives trading is it has grown up as a very concentrated industry, and old habits are hard to break.”
Representatives from the nine banks that dominate the market declined to comment on the Department of Justice investigation.
Clearing involves keeping track of trades and providing a central repository for money backing those wagers. A spokeswoman for Deutsche Bank, which is among the most influential of the group, said this system will reduce the risks in the market. She said that Deutsche is focused on ensuring this process is put in place without disrupting the marketplace.
The man in the middle of that melee (figuring out what to do with Fannie and Freddie) is likely to be Joseph A. Smith Jr., the commissioner of banks for North Carolina since 2002. In November, the Obama administration nominated him to head the Federal Housing Finance Agency, Fannie and Freddie’s regulator.
Yep. There was a hearing last Thursday, and beyond prepared remarks, there was little of note. I didn’t Ticker it at the time as it was a pretty-much pointless exercise; there was little meat there. This week we’ll get the procedural votes out of committee and, presumably, a confirmation vote before The Senate adjourns (maybe; if not, guess who gets to make a recess appointment? Yep.)
When he has testified before Congress in recent years, he has shown a keen interest in saving taxpayers from institutions that are too large and interconnected to be allowed to fail.
He certainly has plenty of ammunition. Janet Tavakoli’s presentation, as I Tickered last week twice, once on her slides and presentation itself, and again on her interview with CSPAN, has presented what looks to this commentator to be a prima-facia case against the banks on the premise of fraud in the inducement, fraud in the execution and fraud in the coverup.
MR. SMITH would also do well to follow another of Mr. DeMarco’s leads: pushing back against the growing chorus of groups arguing for an explicit government guarantee of all mortgages going forward. After what we have been through, isn’t it incredible that anyone could argue for government guarantees of all mortgages? Yet that’s just one of the many perverse “solutions” that have been floated in the aftermath of the crisis.
There should be no guarantees. Period. Credit risk is only properly evaluated and priced when those who make bad loans are forced to eat them. As soon as you can give someone a colorable claim that they’ll be able to force the taxpayer to do it instead credit becomes underpriced and the resulting ramp in unsound loan issuance then turns into a systemic issue.
This is then pressed to lawmakers as “tanks in the streets if you don’t help us” – and instead of locking up the fraudsters, they’re sucked off with the people’s money instead.
The perversity of this is profound. Not only do the people lose their homes and wealth by having the bad loans made and being sold down the river they are then forced at literal gunpoint via taxation or deficit spending that depreciates the currency (and thus is effectively a tax) to pay for their wealth being stolen again!
That’s much like being robbed and when caught, the robber is ordered to pay restitution – but instead of him paying it, the government shows up and sticks a gun up your nose a second time, robs your till to cover the “restitution”, and gives it to the guy who planned to stick-up job – and who remains free and doesn’t go to jail!
There is only one solution that will work: Those who made bad loans must have them forced back upon them and be made to eat the loss. All of it. If this forces them into bankruptcy, so be it. That process is how we clear the credit overhang and by doing so we also pave the road to recovery.
We cannot get out of this swamp until that’s done folks.
No matter how many people will try to tell you otherwise and that there is some other path forward that will work, it simply isn’t true.
Thus far we’ve seen zero intent even when a clear allegation with documentary evidence exists and is made that these acts were not “mistakes” they were intentional.
It’s up to us folks. We can keep playing in the Hopium fog that politicians would love to see us remain in, or we can force these issues into the light of day and put a stop to them.
The latter will not be particularly pleasant in the short run, but it certainly beats the alternative as we watch huge swaths of our population become not only indentured servants to debt (that’s already happened) but slowly slip beneath the water and literally become destitute and die as the noose of these policies and practices – all created and supported by our political system - tighten around 99% of the population’s neck.