Felix Salmon

The arguments for stronger derivatives reform

Felix Salmon
Mar 5, 2010 22:57 UTC

The NYT comes out swinging today, devoting a long editorial to the subject of derivatives reform, under the headline “A.I.G., Greece, and Who’s Next?”. The headline alone made me ill-disposed towards the editorial, even before I got to this:

First came the news that Greece had entered into derivatives transactions with Goldman Sachs and other banks to hide its public debt. Then came reports that some of those same banks and various hedge funds were using credit default swaps — the type of derivative that kneecapped the American International Group — to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro.

What a mess. The news that Greece had entered into derivatives transactions with Goldman Sachs came in 2003, almost seven years ago. The reports about hedge funds using derivatives to bet against Greece and the euro have already been discredited. And AIG was not brought down because people were buying credit protection on it, it was brought down because it was selling credit protection on subprime mortgage bonds.

I’m conflicted about this editorial, because some of its arguments end up in the right place. But the problem is that it gets to the right destination by using the kind of rhetoric which makes it seem as though the only people who are unhappy about proposed derivatives regulation are the people who don’t understand the derivatives market.

“Because the markets in which they trade are largely unregulated,” says the editorial, “derivatives can too easily become tools for dangerous risk-taking, vast speculation and dodgy accounting.”

But dangerous risk-taking is actually a good thing, in financial markets. When people engage in risky behavior on Wall Street, they stand to lose a lot of money, but they know that they stand to lose a lot of money, and government doesn’t end up having to step in and bail them out. The big systemic problems happen when leveraged actors think that they’re not engaging in risky, speculative behavior — when banks become complacent about the credit risk in anything carrying a triple-A credit rating, for instance, or when prime brokers are so overconfident with regard to prices moving smoothly and continuously that they unwittingly put themselves on the hook should a highly-levered fund like LTCM suddenly face discontinuous markets.

The editorial continues:

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings. Private markets also lack the rules that prevail in regulated markets — like capital requirements, record keeping and disclosure — that are essential for regulators and investors to monitor and control risk.

This is typical of the piece: it’s largely wrong, and then it’s right. The CDS market is actually more transparent, with smaller bid-offer spreads, than the cash bond market, and the OTC market in interest-rate swaps, for instance, is likewise just as transparent and participant friendly as its exchange-traded counterpart. Moving trading onto exchanges means lower profits for banks, to be sure — because the trading is moved out of the banks’ trading floors and onto the exchanges. But it doesn’t necessarily mean lower trading costs for the buy side: just ask anybody who tries to buy and sell bonds listed on the Luxembourg exchange.

On the other hand, the editorial is quite right that it’s important for prudential regulators, who are charged with keeping an eye on all the risks in the financial system, to be able to at least see what’s going on in the world of derivatives. And that’s much easier when trading takes place on exchanges than when it’s hidden in bilateral contracts between thousands of different players in dozens of different countries.

The editorial then complains about what it calls a “huge loophole”: the fact that fx swaps are not included in the move to exchange trading. “The rationale for the exclusion never has been clearly explained”, it says; maybe I can help out here. There are a bunch of reasons to exclude fx swaps, including the fact that they take place in a regulated interbank market and are intermediated by CLS Bank, which is also a regulated institution.

But I’m still sympathetic to the NYT’s case here. The administration says that it’s going to give the CFTC broad anti-evasion powers to ensure that firms do not recharacterize interest rate swaps and currency swaps as FX transactions — but no one knows whether and how the CFTC will be successful in that. And the administration isn’t good at explaining why making this recondite distinction between currency swaps and fx swaps (don’t ask) is particularly necessary. Why not just apply the same rules to everything?

Similarly, the editorial is right about the end-user loophole. It’s been tightened up a lot, but why have it at all? I’m sure that banks have the imagination to be able to construct customized hedges for their clients using nothing but publicly-traded derivatives — at least close enough to make most corporate treasurers happy. Yes, those treasurers might have specific needs, but if their hedges aren’t 100% exact, it’s not the end of the world. 95% will be good enough, and might in fact keep those treasurers on their toes a bit more. It’s not good to offer 100% hedges, since perfect hedges don’t exist in the real world, and you don’t want to breed complacency in the CFO’s office.

But this makes little sense to me:

When the House put out a draft of new rules in October, it sensibly gave regulators the power to ban abusive derivatives — ones that are not necessarily fraudulent, but potentially damaging to the system. Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent.

This sounds to me that the NYT wants to ban — or at least give regulators the ability to ban — credit default swaps outright. I’ve written at some length about the incentives facing CDS holders who might profit from a default, but there aren’t evil speculators destroying companies with credit default swaps any more than there are evil speculators destroying companies through naked shorting. Remember that there’s no evidence whatsoever of CDS speculators causing difficulties for Greece. None. Zero. So let’s not get carried away with ourselves here.


“The CDS market is actually more transparent, with smaller bid-offer spreads, than the cash bond market, and the OTC market in interest-rate swaps, for instance, is likewise just as transparent and participant friendly as its exchange-traded counterpart.”

Yes: spreads on ATM OTC IR swaps are razor thin. They have been narrow enough for years to reflect the convexity basis to futures hedging, and nowadays are also CVA-adjusted.

“the editorial is right about the end-user loophole. It’s been tightened up a lot, but why have it at all?”

Because an economic hedge makes an economic difference to the market maker. You do not need as much collateral to take a fixed price from an oil producer as you would to do the reverse trade. Also, the CVA charge to the desk will be asymmetric. In many cases, onerous but pointless collateral requirements would negate the economic benefits of the hedge to the end user. That would make us all poorer.

Posted by Greycap | Report as abusive

Why is Treasury denying its TBTF guarantee?

Felix Salmon
Mar 5, 2010 16:46 UTC

Simon Johnson is right to be dismayed about this:

There is no U.S. government guarantee to protect the largest financial firms, a Treasury Department official said, as a congressional watchdog criticized the $45 billion in government aid provided to Citigroup Inc.

Herbert Allison, who oversees the Treasury’s $700 billion financial-rescue plan, disagreed with members of a congressional oversight panel that some financial firms benefit from the assumption that the government would step in to prevent their failure.

“There is no too-big-to-fail guarantee on the part of the U.S. government,” Mr. Allison said.

The weird thing here is that Treasury itself has made it explicit that there are too-big-to-fail institutions in the US: it even created an official bureaucratic acronym for them: Tier 1 FHCs. These are the banks and other financial institutions which are so big and interconnected that they’re going to need extra levels of capital and prudential regulation in an attempt to minimize the chances of their ever coming close to failure.

But there’s only one reason why the government should carefully regulate a set of companies so as to ensure that they don’t fail. And we all know what that reason is: if they were ever to fail, the government would be forced to step in and bail them out.

It’s also simply false for Allison to assert deny that TBTF banks “benefit from the assumption that the government would step in to prevent their failure”. Even if he’s right that the guarantee doesn’t exist (and he’s wrong about that, just as Treasury was wrong every time it said there wasn’t a US government guarantee of Fannie and Freddie), the fact remains that the markets believe that the guarantee exists, and that the cost of funds at TBTF banks is lower as a result. That’s undeniable.

So why is Allison peddling fiction in front of the Congressional Oversight Panel? Johnson puts it well:

If Mr. Allison was sticking to his talking points, as seems likely, let us find out exactly who is responsible for sharing arrant and self-defeating nonsense with Congress.

It’s a good question. Is this Geithner’s doing? Is Treasury now even more captured by America’s biggest banks than it was in the initial months of the Obama administration? Or is this simply an admission that financial reform is going nowhere, and that we’re going to return to the status quo ante of Treasury refusing to admit that it will ever bail out anybody, and then going ahead and doing that anyway?


This last financial debacle has completely destroyed my and many other Americans respect for capitalism.

There is a bank robber in Denver Colorado named the Limping Latex Bandit who has over the past few months robbed multiple banks and I find myself CHEERING him on! I have decided to join the unlimited number of American citizens who appear to have an endless tolerance for individuals or institutions to steal from them.

I wish anyone the best of luck (as long as no one is physically harmed) who decides to go into any financial institution and take as much us treasury currency as they feel they have a right or need of and hand back to that institution a piece of paper with the sum that you’ve rightfully received written on it…after all, its all fungible.

Posted by csodak | Report as abusive

Jobs chart of the day

Felix Salmon
Mar 5, 2010 15:19 UTC

Ouch. From Catherine Rampell:


The lies of bankers

Felix Salmon
Mar 5, 2010 14:50 UTC

It’s journalism-awards season right now, and I’ve been having a lot of discussions of late about whether and how to give out awards for blogs. And one of the points I make repeatedly is that if you’re going to do that (and I’m not convinced that it’s a good or workable thing to do), then the quality of the comments has to be a key consideration in the judging.

I’m blessed with some wonderful commenters, who really know what they’re talking about. On the subject of getting quotes from investment banks, for instance, ruckandmaul writes this:

For a long tme I had to get “marks” for month end pricing on bonds. These were simply corp bonds for month end pricing. I would call to a couple of dealers and ask for a price on XYZ bonds, “89 by 89.50″. No, I’m not looking to sell just give a price for month end, I always called the shops where we were a big client, “oh, for pricing, 93 by 93.75.” Thanks, remember us the next time you make a trade! How the “marks” were done for CDS nonsense and other esoteric offerings, I can only shudder at the thought.

In a way, it’s astonishing that Simon Treacher even needed to falsify his marks by means of clumsy forgery: wouldn’t it have been easier to just find a complaisant desk on the sell-side somewhere?

On another post, RogerNegotiator finds an astonishing OCC letter, authorizing a bank’s request to adopt largest-to-smallest check posting, thereby maximizing overdraft revenue. (If you have $100 in your account, and put a $1 candy bar on your debit card, followed by a $15 t-shirt, both transactions will end up generating a $34 overdraft fee if a $90 check comes in later in the day: the bank will end up making over $100 in fees that day alone.)

The key section in the letter is the last one, entitled “The Bank’s Consideration of the Section 7.4002(b) Factors”. That section lays out four reasons to adopt the practice, and concludes that “the Bank’s process for deciding the order of check posting is consistent with the safety and soundness considerations set forth in section 7.4002(b) and that the Bank may therefore post checks in the order it desires”.

What are those four reasons for ripping off consumers so blatantly? The very first one is “projections showing that revenue is likely to increase as a result of adopting a high-to-low order of check posting”. That’s considered a reason to adopt the practice, in the eyes of the OCC.

As for the rest of the reasons, they’re mostly ridiculous on their face. I love this one, for instance:

The Bank concludes that it needs to adopt the high-to-low order of posting so that customers who frequently write checks against insufficient funds do not do business with the Bank primarily because the Bank’s fee for checks presented against insufficient funds is lower than its competitors’.

Essentially, the bank is saying that its competitors have high overdraft fees, and that it doesn’t want to compete against its competitors, so it needs high overdraft fees too.

And then there’s this beaut:

The Bank states its belief that a high-to-low order of posting is consistent with the majority of its customers’ preferences. The Bank surmises that the intended order, which will result in a customer’s largest bills being paid first, will have the consequence of the customer’s most important bills (such as mortgage payments) being paid first. The Bank thus concludes that a high-to-low order is aligned with the majority of its customers’ priorities and preferences.

This is accepted at face value by the OCC, instead of simply being laughed at. Of course, no one bothered to ask the customers, because they knew full well that customers would never say that they preferred this way of doing things. But so long as the bank simply says that customers prefer it, no problem.

Overall, what we’re seeing here is banks lying about the value of securities and about their customers’ preferences, and regulators doing nothing about it. And, of course, we’re also seeing how wonderfully rich the comments section of a blog can be.


So, what I’m hearing from the pro-bank crowd, is that it is OK to charge $30 for a $10 loan until friday?

As far as creditcards go, my GF had her rate raised to 27% for no reason at all. They even told her they had no reason to raise her rates, it was just a new policy they had. She has execellent credit and is never late on any payments. They have the right to raise rates for no reason. If I had a car or house loan, could they just raise my rates for no reason? I think it’s about time for some change.

Many people I know, who can afford it, are dumping their cards, I think the credit card companies are shooting themselves in the foot. The people who can pay for cards are dumping them, so only those who can’t afford to drop them are still using them. Those people will no doubt default as they shoulder the load of extra charges. I suspect that credit card companies will be a big story this coming year. I can’t wait to see what happens when we are asked to bail them out.

Posted by Potatoe1 | Report as abusive


Felix Salmon
Mar 5, 2010 06:15 UTC

Me, on To The Point: Whatever Happened to Finance Reform? — KCRW

The day trader with 40 computer monitors — Lifehacker

A fantastic fisking of wild-eyed Marketwatch link-whore Paul Farrell — Josh

“If you have a permanent and complete loss of the use of two limbs, you may take a $50 tax credit” — Weathersealed

Even more incentive for the banks to kill the CFPA

Felix Salmon
Mar 4, 2010 22:18 UTC

Stacy Kaper has a good story today explaining how the CFPA compromise that we seem to be moving towards — putting a toothless agency inside the Fed — is bad not only for consumers but also for banks:

Though the details are in flux, the latest proposal would create a new division inside the Federal Reserve Board that would write new rules for all lenders but have little to no enforcement powers against nonbanks, including check cashers, payday lenders and title insurers…

“We know that the banks will be regulated. If there isn’t effective regulation of the others, then it creates a competitive problem,” said Douglas Elliott, a fellow with the Brookings Institution and a former investment banker with JPMorgan Chase & Co. “They are instinctively looking for a relatively weak agency here, but if it ends up being a weak agency that allows a lot of nonbanks to compete through fraudulent or near-fraudulent behavior, that’s not good for the banking system.”

The problem of non-bank lenders is a huge one: most existing regulatory institutions were created to protect depositors, rather than borrowers, and as a result just about anybody can lend however much they like to whomever they like on whatever terms they like sans any real regulatory oversight at all. That in turn creates a disastrous race to the bottom as banks try to compete with unregulated lenders, and in the end everybody — banks, consumers, non-bank lenders, the lot — finds themselves heaped up, broken and crumpled, in the corner (solution).

The banks know this, of course, and as a result they’re well aware that they have a huge incentive to kill the CFPA outright, rather than allowing it to reside within the Fed. That’s almost the worst-case scenario for them: they get a consumer-protection agency breathing down their necks (even toothless regulators can breathe), while non-bank lenders can act more or less with predatory impunity unless and until they grow above $10 billion in size, stealing customers from banks and gouging them freely.

Since it’s pretty much unthinkable that the bank lobby will ever support a strong independent CFPA with jurisdiction over all financial services companies, then, my feeling is that they’re going to be very happy indeed if nothing comes out of the Senate at all — or, in any case, nothing remotely acceptable to Barney Frank. And since the bank lobby tends to get what it wants, my base case for consumer protection is now a big zero. (Or, rather, the same mess that we’re living with currently.)

At that point, as I’ve said in the past, Elizabeth Warren should just go it alone and create a Consumer Financial Protection Agency entirely unafilliated with the government, which would give out “consumer friendly” badges for financial institutions which meet its standards, and which would have a high-profile bully pulpit from which to name and shame those institutions which rip off their customers. It’s better than nothing — and in many ways it might even be better than the kind of compromise that Kaper’s talking about, too.


It could be argued, the Federal Reserve isn’t affiliated with the government seeing as how it’s basically a consortium of mega-banks that do more or less whatever they want under the guise of “public interest”, screwing the public included. That’s exactly what they aim to keep on doing, too.

Their stated objection to not having control over “nonbank” lending practices appears to pivot – per Kaper’s article – more than anything else around the prospect of open competition from non-TBTFs, by which they surely don’t mean payday lenders. Ergo it’s smaller, truly competitive banks the cartel’s really out to get; the subtext being, they won’t rest until what’s handed them on a plate are everybody else’s heads, using payday lenders as the Trojan Horse to hard-sell iron fist re-standardization without representation.

A 100% independent CFPA would not only seem to be the only way impartial standards enforcement could be attained – it *is* the only way. How badly reserve banks dislike this idea is a measure of how good and essential it is.

Posted by HBC | Report as abusive

AIG was even sleazier than you thought

Felix Salmon
Mar 4, 2010 21:04 UTC

I knew that AIG was technically a thrift, but I thought that was just a piece of nimble-footed regulatory arbitrage in an attempt to get itself regulated by the pointless Office of Thrift Supervision. It turns out, however, that AIG was actually a pretty substantial mortgage lender, through its AIG Federal Savings Bank and Wilmington Finance subsidiaries. And a racist one, too. From the complaint:

From July 2003 to May 2006 black borrowers nationwide were charged total broker fees 20 basis points higher! as a percentage of the loan amount, on average, than the total broker fees charged to white borrowers for WFI and AlG FSB’s loans. These disparities extended to at least the following 19 metropolitan areas in which AlG FSB and WFI made a substantial number of brokered-loans-to black-and white-borrowers: Atlanta, Baltimore, Birmingham, Cincinnati, Chicago, Cleveland, Detroit, Hartford, Kansas City, Las Vegas, Memphis, Nassau County, New York, Orlando, Philadelphia, Phoenix, Portland OR, St. Louis, and Tampa. In these MSAs black borrowers paid total broker fees ranging from 25 to 75 basis points higher, on average, than the total broker fees paid by white borrowers. All of these disparities are statistically significant.

AIG has now settled the case, paying a minimum of $6.1 million in fines. But there’s no hint of the case in its newsroom as yet.


Alleged civil rights violations are only one part of this. AIG is a still-unfolding train wreck.

AIG deserves a name in the economics text books: not only a failure, but one of capitalism’s larger deformities.

Corporations that exploit the American population are unpatriotic.

In future years, tourists on buses will be driven by AIG to hiss and jeer.

Left Blog


Posted by reverse_cloud | Report as abusive

The SEC: still toothless

Felix Salmon
Mar 4, 2010 20:25 UTC

Does Mary Schapiro’s SEC have teeth? There was hope that it might, when she was confirmed — but the tale of her treatment of Salvatore Sodano, the former CEO of the American Stock Exchange, indicates otherwise.

Gary Weiss has the full story, but suffice to say that after finding him guilty of failing to enforce securities laws, the SEC tried to censure Sodano, but he appealed, and, last week, the final decision came down: Sodano was indeed guilty. “Respondent Sodano, without reasonable justification or excuse, failed to enforce compliance with the Exchange Act”, the SEC said. And… that was it. Writes Weiss:

There wasn’t even a censure, much less a more appropriate gesture—such as forcing him to cough up some of the handsome pay that he had accrued at the Amex, where he was CEO from 1999 to 2004. Sodano, who served as chief financial officer of the National Association of Securities Dealers before coming to the exchange, enjoyed $4.4 million in salary and bonuses in 2002 alone.

The symbolism here is important: the SEC needs to show that it has turned over a new leaf when it comes to enforcement actions. This case is hardly encouraging in that respect.


Eh, the termites have eaten through the old house. Time to build a new one with new termite-proof materials. End of story.

Posted by UncleBillly1 | Report as abusive

Greece reaps the benefit of its CDS market

Felix Salmon
Mar 4, 2010 18:31 UTC

Great news from Greece: its brand-new €5 billion, 10-year bond issue was three times oversubscribed and is already rising in the secondary market, after pricing at a spread of 300bp over the mid-swap rate. Greece is paying a 6.4% yield on the issue, which is pretty affordable in the grand scheme of things, given how much trouble it’s in right now. And now that this bond has gone so well, there will surely be appetite in the market for more where that came from.

One of the big problems with debt markets is that, especially during times of stress, they become very illiquid. Many bankers have spent many hours trying to explain to emerging-market finance ministers that just because their bonds are trading at a certain level in the secondary market, that doesn’t mean they can issue new bonds at that level, or even at all.

But it turns out that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. Which is yet another reason to laud the notorious buyers of naked CDS protection, rather than demonizing them.


“It turns out” that “it turns out” is not a valid way to get from a bunch of sketchily supported premises to a barely-related and probably-false conclusion. The ability of Greece to access the credit markets depends on the appetite of buyers for Greek credit risk. Thanks to the wonders of moral hazard and the continued willingness of governments to stiff taxpayers in order to bail out bondholders, buyers are hungry for Greek credit risk, since it appears to be German credit risk + 300 bp. Bill Gross did really well with this trade in the U.S. – FNM, FRE, C, and BAC debt all became almost equal to Treasuries. This trade is a redistribution of wealth from taxpayers and prudent investors to those who speculate on bailouts. Of course, if no one bails out Greece the speculators will eat it big-time, but rather than a working out of market forces we now have a guessing game of whether governments will take losses away from moral hazard investors and give them to the more prudent. I don’t know what this has to do with the CDS market, which only moves around existing credit risk.

Posted by najdorf | Report as abusive