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Deriving the Truth - Brooksley Born wants the public—and Wall Street—to understand unregulated...
City Journal ^ | 14 January 2010 | Nicole Gelinas

Posted on 01/18/2010 4:21:48 PM PST by neverdem

Brooksley Born wants the public—and Wall Street—to understand unregulated derivatives’ role in the crisis.

At yesterday’s Financial Crisis Inquiry Commission hearings, Brooksley Born, one of the 10 commissioners on the Congressional panel, didn’t use her time taking cheap shots. Born, who ran the Commodity Futures Trading Commission (CFTC) under President Clinton, asked modest questions of Goldman Sachs chief Lloyd Blankfein. The details that she tried to uncover are the financial crisis, distilled.

Born confined her questioning to inadequately regulated, or “over the counter,” derivatives. It’s easy to see derivatives as peripheral to the “mortgage crisis,” but they were actually central to it. Derivatives are financial instruments that get their value from other securities or markets. When derivatives are properly regulated, traders must put a pre-determined percentage of cash behind their bets, right from the outset. A central clearinghouse holds that cash, along with cash from other investors. If one financial firm can’t pay its obligations, the clearinghouse can make good on the bankrupt firm’s promises. Risk-taking is robust within a controlled environment.

But over the past two decades, the financial industry created instruments that evaded these rules. Through unregulated credit derivatives, the insurer AIG made nearly half a trillion dollars’ worth of promises related to the value of mortgage-based and other debt securities. AIG and its trading partners, including Goldman Sachs, signed agreements that called for the insurer to make large, immediate cash payments that depended on sudden, unpredictable market moves—but AIG didn’t set cash aside for this purpose in advance.

When markets moved the wrong way, AIG couldn’t make good on the payments Goldman and others demanded. And because the contracts didn’t trade on central clearinghouses, nobody knew where the risk lay—and which other financial firms AIG’s default would bankrupt. These unknowns set off mass panic until the Fed and the Treasury announced that they would stand behind AIG’s promises, including those it made to Goldman Sachs.

Yesterday, Born honed in on unregulated derivatives’ role in precipitating the $182 billion AIG bailout, still the object of public wrath. Earlier that morning, Blankfein had testified(pdf) that requiring derivatives to trade on central clearinghouses, with enforced cash-down requirements, would “do more to . . . reduce systemic risk” in the derivatives markets “than perhaps any specific rule.” Born asked Blankfein to explain unregulated derivatives’ broader role in the financial crisis—in effect, to explain why fixing this problem was so important, not just for derivatives but for the economy as a whole.

Blankfein then took refuge in generalities and absurdities. “Aspects of the over-the-counter derivatives market were a very, very big concern and a big worry,” he said: the generality. And then the absurdity: “My belief is that the derivatives market functioned actually pretty well under the circumstances. . . . We didn’t specifically have a derivatives crisis.” Blankfein’s evidence was that after Lehman Brothers, Washington Mutual, and a few other firms defaulted in September 2008, the holders of credit derivatives related to those banks’ failure managed to pay out on their obligations.

But Blankfein neglects a key point. Markets did this settling up after the government realized what a colossal disaster Lehman’s bankruptcy meant for the global economy. When Lehman made clear that it would file for insolvency on September 14, lenders to the world’s financial system stampeded for the exits. They did so partly because they were terrified that Lehman—and the then-flailing AIG—would owe a then-untold amount on derivatives markets and that payment wasn’t going to happen. They weren’t afraid just because Lehman had gone bankrupt; they were worried about who else would go bankrupt. The government muted the panic and saved the shell of the financial system only by pledging not to let it happen again. To prove it, the feds saved AIG the next day.

Born pushed Blankfein again to make the connections. “Do you think [with] the failure or near-failure of AIG, . . . do you think that having [central] clearing [of derivatives] would have . . . reduced the risks inherent in AIG’s position?” she asked.

Blankfein wouldn’t bite. “I believe that it may have helped a bit,” he allowed, explaining that a clearinghouse could have wrung cash payments out of AIG, which was “slow” in making them. But, he concluded, “AIG was bent on taking a lot of credit risk. . . . It was a failure of risk management of colossal proportion, and there were derivatives in there.” Without unregulated derivatives, the Goldman chief said, AIG “could have substituted other vehicles.” Blankfein failed to seize the opportunity to make a vital distinction: under a proper system of regulation, a bankrupt AIG would not have threatened the financial system.

Yesterday, a witness in the hearings’ afternoon session, J. Kyle Bass of an independent investment firm, Hayman Advisors, said(pdf) what Blankfein should have said. “AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did, had they been required to post initial [cash] collateral on day one . . . [I]n AIG’s case, they did not have to post collateral. . . . The so-called ‘initial’ margin was, and still is, only charged to counterparties that are deemed to be ‘of lesser credit quality.’” (AIG enjoyed near-perfect credit, until the firm used it to help bankrupt the financial system.)

Bass concisely offered solutions. Regulators should require derivatives participants—and presumably, participants in markets that haven’t been invented yet—to post “homogenous minimum collateral requirements” at the outset of their trades through a central clearinghouse “based upon a formulaic determination of risk. . . . This would prevent . . . an AIG-type scenario where hundreds of billions of dollars in risk is assumed with no cost.”

Note two of Bass’s words in particular. “Initial” is important. AIG’S trading partners did demand cash—but only after it became apparent that the securities against which AIG had made its promises were deteriorating. By then, it was too late. “Homogenous” requirements would protect the economy from the inability of the financial industry and the government to predict what’s risky in advance. If AIG had to put 10 percent down on its promises from the beginning, we would not have seen the panic that resulted from its fall. Market participants would have known where the risk lay and who was responsible for losses (the clearinghouse).

This lesson isn’t new. Born tried to get Congress to understand it more than a decade ago. After the Long-Term Capital Management hedge fund teetered in 1998, precipitating a government-led bailout of its lenders, she recognized the significance of what had happened. She concluded—correctly—that it was unregulated derivatives that had allowed Long-Term Capital Management to spin just $2.3 billion in investor capital into $1.25 trillion in potential liabilities without anyone noticing.

Just like AIG years later, Long-Term Capital Management and its lenders—the world’s biggest banks—avoided the rules that were supposed to ensure that bad financial bets could not imperil the economy. When Long-Term bet wrong, markets panicked. The world’s investors knew that the hedge fund couldn’t make good on its derivatives promises. Even worse was what investors didn’t know: which financial firms the hedge fund’s default might cripple. The New York Fed determined that markets couldn’t withstand the hedge fund’s bankruptcy. It forced banks to prop it up and then wind it down over time.

In the wake of this near-disaster, Born warned Congress that derivatives markets needed old-fashioned regulation. She told the House Financial Services Committee in 1998 that these markets posed “unknown risks to the U.S. economy and to financial stability around the world” because of their “lack of transparency” as well as “unlimited borrowing . . . like the unlimited borrowing on securities that contributed to the Great Depression.” But Washington and Wall Street saw the bailout as a success that proved they could handle these markets on a discretionary basis. So Congress, counseled by then-Fed chief Alan Greenspan, passed a law forbidding such regulation. A decade later, unregulated derivatives overwhelmed Wall Street’s ability to bail itself out.

If the Financial Crisis Inquiry Commission can get the American public to grasp just one thing, it should be that properly applying old rules to new financial instruments goes a long way toward solving the “too big to fail” problem that infects our economy and is at the root of public anxiety. AIG could not fail in 2008, because if it had, its unregulated derivatives would have blown up the financial system from the inside. The FCIC needs Congress, which has offered up a loophole-ridden derivatives fix, to get this, too. Otherwise, Wall Street will one day take on such mammoth liabilities that it overwhelms even Washington’s ability to bail it out.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of After the Fall: Saving Capitalism from Wall Street and Washington.

TOPICS: Business/Economy; Crime/Corruption; Editorial; Politics/Elections
KEYWORDS: aig; born; brooksleyborn; derivatives

1 posted on 01/18/2010 4:21:49 PM PST by neverdem
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To: neverdem

Here is a key line from the beginning of the article:

“Through unregulated credit derivatives, the insurer AIG made nearly half a trillion dollars’ worth of promises related to the value of mortgage-based and other debt securities.”

These derivatives were based upon values of mortages that were forced uponthe banks to begin with. Though some want to lay the blame on how financial institutions tried to make these bad mortages that were forced upon them profitable.

Those who continually want to make it seem that it was a lack of regulation that caused this financial crisis continually point to problems that resulted after the fact.

Of course financial institutions are going to try to be profitable and they will always try to figure out ways to get past the crappy fascist intrusion of political agendas into the market.

It was no secret that this type of practise was going on. The democrats supported it because it was helping prop up their market bubble created by the CRA and it helped appease their political base and groups like ACORN.

This article does not recoginise the core of the finanical problem but only points to after effects that were created by the core problem to begin with.

2 posted on 01/18/2010 4:42:15 PM PST by TheBigIf
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To: neverdem

I agree on a “clearing house” approach and more up front cash requirements for derivative type investment instruments created by, offered by, or bought and held by a financial institution, but ONLY if that institution is a government institution (like a government pension fund) or has some sort of government guarantee on some portion of it’s assets (like a bank with FDIC deposits). The rest can do want they want, and if they fail then their assets (what’s left) and their customers, will readily be picked up by someone else.

3 posted on 01/18/2010 4:51:09 PM PST by Wuli
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To: Wuli

India, China and Canada’s banks escape the meltdown simply by not allowing derivatives. Keep it simple, let Wall Street have some leeway and they will screw the country again with the same instrument.

4 posted on 01/18/2010 5:00:00 PM PST by Fee (Peace, prosperity, jobs and common sense)
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To: Fee

Yea and India, China and Canada also do not have Fannie or Freddie or the CRA or ACORN as well. This article still diverts from the real core problem of the financial crisis.

5 posted on 01/18/2010 5:16:13 PM PST by TheBigIf
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To: neverdem

According to Goldman’s Blankfein “The System Worked”

6 posted on 01/18/2010 5:29:05 PM PST by nkycincinnatikid
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To: neverdem
There are many banks and investment funds that did participate in derivatives (usually small or regional), in North & South America, Asia and Europe and also escaped the bloodbath

Why? There is nothing intrinsically wrong with the concept.

But, three “simple” things can, and did, make the difference;

not accepting at face value what is said about the derivative being offered (you don't have to accept what S&P, Moody's, etc., say about it either);

doing your own due diligence (instead of waiting for a “clearinghouse”), which includes not only due diligence about the derivative itself, but due diligence on the marketplace of the assets from which the derivative is derived;

and determining what is a prudent mix of the different investments you hold - which is contextual to the type of business and the business plan, customer and fiduciary responsibilities, and capital requirements that those things expect, or require.

The giants that failed in the financial system most often went with the herd in their own class and circle and failed to do enough of those simple things that many smaller and regional institutions thought (knew) they had to do - because THEY knew THEY had neither the taxpayer's implicit guarantee to back-up their errors, nor a revenue mountain large enough to earn back extra losses very quickly.

The majors were simply too arrogant for their own good.

One of the the biggest errors with derivatives that the major institutions did was not that they held any derivatives, but the size of that class of assets and liabilities that they allowed derivatives to become, as a portion of their total assets and liabilities.

Some prudent minded people avoided derivatives and did well. Some other prudent minded people did not stay out of derivatives altogether, but prudently did all their own due diligence and prudent weighting of assets and liabilities in their capital requirements, to avoid excessive risk and they too avoided the blood bath.

I have no need to kill derivatives.

But if someone is going to use them, I want better regulation over THEIR capital requirements, IF, and ONLY IF, any aspect of THEIR business implies any taxpayer protection (like FDIC insured deposits) for THEM. But if THEY CANNOT come to the taxpayer for financial protection, they are neither too big nor too small to fail. Their failure will only create some bargains for those who were more prudent minded.

7 posted on 01/19/2010 3:00:47 PM PST by Wuli
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