Saturday, February 6

Playing by the rules

New regulations recently proposed for publically listed US financial institutions aim to prohibit proprietary trading (that is trading by the bank for the bank rather than on behalf of clients) and restrict investments by those public institutions in hedge funds. In a further recently mooted change hedge fund and private equity traders are to be subject to ordinary income tax rates, in lieu of the lower capital gains tax rate that currently applies to their free equity stakes.These long overdue proposed changes once implemented will limit banks ability to place bets on the markets and reduce some of the speculative trading which featured in the global financial crisis.

A recent poll indicated 77% of investors thought such measures were anti –business and a number of business luminaries continue to be critical of the Obama administration citing the probability for tightening of business credit as an unintended consequence. Personally I think such moves will prove to be very positive for the banking sector, and, combined with recently announced increased support for community banking will not impinge on banking services as feared.

However no effective changes have been announced in response to the more critical causes for the prior global financial collapse which was due to the unprecedented growth in leveraged non transparent derivative trading and particularly in the form of credit default swaps. It was the subsequent failure of counterparties dealing in these instruments, which precipitated the turmoil and collapse in markets and these new measures fail to address these issues excepting that public firms will now be prohibited from taking a principal position in trading firms involved. Credit default swaps continue to be traded under a system where virtually no rules exist over their issuance or in market transparency.

How do they work? –

There is a price paid by a buyer to a seller for cover for a bond or a loan where the seller is liable in the event of a defined event termed a default. Hence the buyer buys protection from a seller in consideration for a future payment if a bond or loan defaults whose events are generally defined as bankruptcy, restructuring or due to a credit rating downgrade.

However this seemingly innocuous idea for parties wishing to cover their exposure to loans or bonds is far removed from the typical Credit default swap which operates in the market today. The amount typically paid is a measure of the decrease in the market value of the referenced obligation arising from a credit event, usually without any regard to whether a holder actually suffers a loss. This has lead to the market participants to characterize credit default swaps as “covered" or "naked." A "covered" CDS refers to a transaction in which the protection buyer has an economic exposure which is more in line with sensible commercial principles. However virtually all credit default swaps provide that the parties to the swap need not own the referenced obligations.

The "naked" Credit Default Swap is where the protection buyer does not own or have economic exposure whatsoever to the underlying instrument.

Furthermore Credit default swaps can be used to mitigate the risk of defaults in a debt portfolio market value where a holder of a bond, may hedge exposure risk by buying protection in a Credit Default Swap with respect to that bond. Should the bond default, the proceeds from the Credit Default Swap will cover the resulting decrease in market value of the underlying bond. But if the bond subsequently recovers value, as is oft the case the Credit Default Swap protection buyer will have received reimbursements despite the fact he never suffered a loss.

By now it is apparent to even the most casual observers Credit Default Swaps although touted as resembling insurance policies are vastly different in a number of critical areas; E.g.

  1. There is no requirement to actually hold any asset or suffer any loss as payments can be triggered for various events, providing an opportunity for coercion and market manipulation.
  2. There is often no insurable interest between the parties or any incentive not to make claims. Traditional insurance seeks to work out schemes of arrangements with defaulters or to help mitigate respective party losses. There is usually an element of a self insurance loss in any financial or trade insurance which mitigates against fraud or prior inadequate disclosure of the risk.
  3. The parties can profit in the demise of a company. It is often in the interest of the holder to hasten the firm’s demise as the holder stands to profit from such an event. Hence the opportunity for market manipulation.
  4. Prudential requirements do not apply to the issuer of these instruments and a highly geared hedge fund can sell a large amount of credit default swaps without the need to have mandated reserves to cover any subsequent losses which may be higher than anticipated.

One might well ask how such reckless arrangements to open the door to coercion and market manipulation could ever come into existence in the public company arena in the first place.

A significant milestone on the road to the ensuing chaos occurred in 2000, when Congress passed a piece of seemingly innocuous legislation called the Commodity Futures Modernization Act, which made derivatives off-limits to agencies that regulate stocks, bonds and futures contracts and was subsequently signed into law in December 2000. The reality of such legislature to exempt regulatory control was to open the door to a form of derivative trading which was to inflict havoc in markets and lead to some of the worst market excesses in 60 years and subsequent failure of counterparties.

An interesting analogy would be to exempt a sport temporarily so that the rules are, there are no rules. I would suggest severe chaotic outcomes would be experienced immediately since inevitably some form of guidelines is required for any game together with the desire to appoint an umpire. Democracy is after all a system that depends upon fair and equitable distribution where players play by the rules, the alternative being corruption and acceptance of that corruption as your corrupt way of life.

Let’s hope eventually, in addition to the recent moves we also see a return to common sense regulatory measures.

12 comments:

susan said...

This is a very thoughtful and well put together post about the problems we've seen in this country over the past few decades that finally created the massive collapse of two years ago. I agree that more regulation would be an excellent idea but the problem is that rather than be taxed a preponderance of the super rich decided to buy legislators rather than pay their fair share of taxes. The current administration should have started out of the gate with a much stronger message about fairness and now it may be too late to accomplish the kind of serious changes in economic policy that would improve things in the long run. We'll have to see how it all plays out.

Michael Manning said...

I found this very interesting and thoughtful. We all wish to learn more about what caused the U.S. economy to tank. It is not an easy task. But you have shed some light here. Thanks!

Sandra said...

OBAMA and Bernanke are featured in a movie-- about greedy hedge funds called "Stock Shock." Even though the movie mostly focuses on Sirius XM stock being naked short sold nearly into bankruptcy (5 cents/share), I liked it because it exposes the dark side of Wall Street and revealed some of their secrets. DVD is everywhere but cheaper at www.stockshockmovie.com

Mercutio said...

Wall Street will always cry out against any manner of regulation, even those that prove to be beneficial on the whole.
The fact of the matter is that financing (banks being in the business of lending money) has suffered significantly over the past two years.
My view is that things will take a bit of time to unravel.

As for myself, I have a rule that I never invest in something that I don't understand. And frankly, I don't understand CDS's enough to want to buy in. Especially not when there's plenty of money to be made elsewhere.
I made a small fortune going short on pounds a few months ago, and the principal was relatively little. I'm only one fellow, and I had very little real effect on the British economy (I hope!).
Which makes me wonder what type of returns are to be had with CDS's.
I really don't see any need for them.
But I welcome additional regulation.

Mercutio said...

Just to say, the British unemployment numbers came in higher than expected, and the pound dropped like a rock.
I sold several lots on the margin, an insane amount of money. Standard contract is for two days delivery, I believe.
When the pound went down far enough for me to take profit, I bought enough lots to dump the contracts.
Easy money.

That's something that I understand.

Lee said...

Good to see you're still blogging, Lindsay. I've been absent for a while, but hopefully, I'll be more frequent from now on. I don't know where the time has disappeared to!

Mercutio said...

Pardon me, Lindsay, but I was wondering if you could go through this one more time for the incredibly stupid among your readership.
I understand "credit." I understand "default." I understand "swaps." But credit default swaps somehow elude me.

Now, suppose I hold stakes in a uranium mine in Colorado. The refinery fills the car with uranium, and the train is coming down out of the mountains.
On its way down out of the mountains, all of a sudden its credit default gets swapped.
What happens to the uranium? Has a terrible mishap occurred? What would be my liability?

I'm just trying to understand this.

lindsaylobe said...

Hi Susan, Michael, Sandra, Mercutio & Lee
Thanks for your visit.
Susan
Thanks for your encouraging remarks. I think there is room for mild optimism now that Paul Volker seems to have more sway.
Michael
It’s far more complex than just this aspect which nevertheless was a contributing factor- thanks for the feedback.
Sandra – Thanks for the reference
Mercutio
You cannot have a foreign exchange market without speculators whose speculation is of interest to others willing to take a counter position. Providing a transparent market exists with adequate regulation there is no problem since this is zero based end game.

In relation to your question about a CDS, bear in mind we are talking about a derivative arising from the debt market (not the equity market) where a buyer pays a fee to cover the credit risk of an underlying bond, loan or any other financial asset, but not cover for a direct investment or share or equity investment as your example seems to want to imply. I think your confusion may arise from the use of the word swap. In short term agreements the fee paid by the buyer is paid up front and they are called credit default options. When the fee is paid over a period of time the term swaps crept into the market since counterparties could swap credits during the period of the agreement and make up the difference in price as the case may be.

Hence the fee is paid upfront for very short dated structures where the term credit default option is used. But usually the fee is paid over time and the agreement is called a swap, since counterparties can swap and exchange the credit default during the term of the agreement.

Derivatives business is oft run by banks that used to run interest rate swaps e.g. you swap a variable short term interest rate with review for a longer fixed rate or vice versa, so that that swap type terminology still persists today.

I suggest you don’t read too much into the idea of swaps since it is only a means of the buyer amortizing the original option premium paid. They are a type of credit default insurance relating just to the credit market, nothing to do with operational physical commercial performance at a plant as such. That would more be in the province of a performance bond in relation to a contract at a plant- nothing to do with my post or CDS which are about credit defaults.

Hence I could only use your example to the extent to illustrate that if you held any investments in any corporate debt instruments in the uranium mine in Colorado and they defaulted on their repayment of that corporate debt or suffered a credit downgrade (which was covered by the CDS) then, should you hold a CDS your able to make a claim against the seller of the CDS.
The insurers (those issuing or selling the CDS) manage their risk usually by setting up loss reserves to satisfy future claims based upon probability factors. The dealers in the CDS market on the other hand will manage their risk usually by hedging with other dealers and transactions in the underlying bond markets. The total market in CDS is huge and includes sovereign risk of public debt between countries.

Hi Lee
Welcome back – I will call-in and say hello shortly.

Best wishes

Mercutio said...

Thank you for your patience, Lindsay.
Options are something that I understand.

Seraphine said...

there ought to be limits on the types of investments banks are allowed to make, when they are using government-guaranteed money to make them.
"public" money should be treated separately from "private" money.
and public money, especially, should be invested in transparent instruments. it's not just the banks that are guilty- look at the financial troubles the country of greece is having by investing in derivatives in order to 'hide' the true scale of its debt.
you can pay peter by borrowing from paul, for a while, but eventually the bill still comes due.

gfid said...

one of the best lessons i learned when i took my business training (majoring in accounting and finance) was that my personal bottom line is not financial. and i, like Mercutio, don't put my money and efforts into things i don't understand. nor in things that are created for the sole purpose of making money. i'll invest in real property or business that can and does provide real things for real people, but the concept of buying something just because i think someone will want to pay me more for it in some future time somehow offends me. which is why i am not, nor ever will be affluent. but i'm deeply content, and grateful that i have a simple decent home that i own, frequented by many dear friends. i never go hungry, and i have enough to share. this is a good deal more than a large percentage of the people of the world can say..... and for me it's sufficient. it's beyond my comprehension what USE incredible wealth is. it doesn't seem to make those who acquire it any happier, or make the world a better place.

lindsaylobe said...

Hi Sera & Granny F
Thanks for your interest
Sera

Transparency does need to apply universally to not only public companies ( particularly where taxpayer public money is invested in public corporations) but also in ‘markets’ to avoid insider trading and corruption.

Hence the link of non disclosure to avoid the rules to gain commercial advantage.

In the US you would be aware of the export of swap finance facilities which were arranged by a prominent US bank to Greece in order to ensure the EU rules were circumvented. Greece incidentally still maintains the facility was arranged in such a way to be legal at the time and did not require disclosure to the EU. This goes to the heart of primacy of purpose and the idea that a lot of money can be made if you’re sufficiently creative to deliberately engineer products to circumvent the rules for those desperate enough to get around the rules at the time.

Creative accounting is hardly something new but once again has reared its head in the so called ring of fire with Greece, Portugal and Spain and in the US. It’s back to basics to return to a state of integrity and I remain confident we can learn from the GFC and begin to live more sensibly in the decades ahead. That is until it is repeated in a different format.

Granny F
I think the vast majority of people investing one way or another – be it a family home or property, super or retirement funds or in businesses or shares in companies are only seeking a sustainable future return and are not greedy. It is true there needs to be some incentives and reward for the sacrifices one makes to run any big organization but exec salaries and benefits are way out of proportion and becoming the primary reason for continued societal disharmony.

It sounds like a cheap cliché but it’s true that all over the world aid workers say they find the happiest people amongst the poorest nations.

Best wishes