Derivatives

I have to admit I was very pleasantly surprised by the proposed derivatives regulations that came out of the Senate's Agriculture committee — so much so, that I think it would be fantastic if somebody could find a way to assign farm price supports, the next time they come up, to Banking and Finance.

Blanche Lincoln provided real leadership, and Charles Grassley bravely decided to satisfy Iowa voters rather than adhere to monolithic Republican Party discipline. (Well, maybe he had permission.) However it happened, the bill reported out of committee is significantly better than the House version.

Perhaps it's because those farm state Senators have a genuine understanding of the way derivatives are supposed to work. The reason Agriculture is responsible for derivatives is because farmers need futures contracts to manage risk . Those contracts always have been traded openly and, by and large, they have done the job for both farmers and end users of agricultural products. Markets do work, provided they are not diddled by those who look for ways to profit from market failure.

So now it's "wait and see" time again. I don't think the Republicans are dumb enough to filibuster a financial reform bill, but who knows? With enough pressure from Fox News and the minions of Dick Armey, it still could happen.

More important to the final bill, though, is what comes down from the White House. Geithner and Summers have been mouthing some of the "correct" pronouncements lately, but nobody ever should forget just how much money Wall Street has to sling around. A hell of a lot was tossed at Obama during the 2008 campaign, and thanks to the Supreme Court's decision in the Citizens United case, there will be a hell of a lot more to be tossed around in the future.

Financial regulation

On health care, the Obama administration sat back and waited for Congress to come up with something — anything. On financial regulation, the bill came straight from the administration, and it sailed right through the House.

Obama, as I've noted in the past, picked the wrong Bob — Rubin, rather than Reich. That left us with Geithner and Summers, zombie slaves of the financial industry. I'd feel a lot happier about the package from the White House if it had been written by people less ideologically committed to Wall Street. When a bill starts out weak, it only can end up as an even weaker law.

Oddly enough, I find myself in agreement with the likes of Richard Shelby and John Cornyn on at least one point: it is time to revisit the 1995 repeal of Glass-Steagall, one of the most unfortunate legacies of Robert Rubin's time in the Clinton administration. Commercial banks and investment banks should, once again, be separate — if for no other reason than to reduce the overall size of the largest institutions. Even if that were done, though, there are some institutions which would need further whittling down to ensure that there no longer are any that are "too big to fail."

At this time, the biggest banks have an unfair competitive advantage over smaller banks, in that they can borrow money at lower rates. They get those lower rates because it is assumed that government will not allow them to fail, no matter what pledges come out of Congress and the White House — and they use their surplus profits not to invest in productive businesses, but to place bets in the high-stakes casino Wall Street has become over the past fifteen years.

I can see absolutely no reason for synthetic CDOs to exist. They are nothing but side bets on real economic activity, but bets large enough to disrupt the financial system and create crises. Credit default swaps on synthetic CDOs were a large part of what brought down AIG, and made its government bailout necessary. If the very rich want to make bets on whether bonds they don't own will or will not default, let them open their own betting parlor and gamble with their own money — not with our pension funds.

Other derivatives must be openly traded, on an exchange like the one provided for in the bill now before the Senate Agriculture Committee, but with no exceptions for companies that are particularly large or well-connected. Markets cannot operate properly when they operate in secret.

Naturally, I don't expect much of the current effort to improve financial regulation, but hope it might be a step in the right direction. Yes, my fingers are crossed — but I'm not holding my breath.

Economic reform?

Why are the stock markets doing so "well" lately? Clearly, it's not because the businesses whose shares the markets trade are posting increased profits. Some of the increase in stock prices may be accounted for by the falling value of the dollar — as the dollar weakens, it takes more dollars to buy anything — but that's not the whole story.

Who, we may wonder, is bidding up the price of stocks, and where are they getting the money to do it in this economic environment? Look no further than the investment branches of our banking behemoths, using cheap, government guaranteed credit. To me, it's looking like another bubble — and given the poor shape of a lot of American businesses, it seems pretty obvious that their price to earnings ratios over the past few months have been falling like it's the nineties again.

A lot of people are blaming a handful of conservative Democratic senators for the lame, half baked efforts coming out of Congress for reforming the financial system. I suppose they have their part to play, but the real fault lies with the White House.

If the Obama administration genuinely wanted to bring Wall Street to heel, it could be making a far more aggressive effort than we've seen. Fiddling with executive pay packages may score a few populist points, but in the long run (or even the short run), it means nothing. Some of us remember that the whole corrupt bonus system arose out of efforts to rein in executive pay during the Carter administration.

As for regulating derivatives, there are enough holes in the proposed legislation to accommodate every rat looking for a way through — and damned near as many in the proposal for the consumer protection agency. Instead of breaking up the institutions that were "too big to fail," government has helped them grow even larger through mergers and acquisitions.

Paul Volcker has been out there, crying in the wilderness for genuine reform — rolling back the Clinton administration's gutting of whatever remained of Glass-Steagall, and separating banking's commercial and investment sectors again. The White House will not be doing that anytime soon — at least not as long as two of the three Clintonistas who engineered that gutting remain in power. Robert Rubin may be gone, but he left Larry Summers and Tim Geithner behind to look after the interests of the Wall Street power brokers.

Well, viva Volcker. The White House is ignoring him, but at least he's getting some attention in the press.

Regulation, again...

Well, I'm still waiting to find out just how "customized" a derivative has to be to escape regulation. So far, it sounds like the bankers will be a lot happier with the outcome than I will.

So far, a substantial majority of the derivatives that have been created have been "customized" to one extent or another -- and the bankers insist that such customization is vital to "serving the interests" of both buyers and sellers. Okay. It makes sense that different CDOs requires different terms and due dates. It makes sense that different credit default swaps will insure different levels of risk to different degrees. Swell. Go ahead and customize them.

I also understand why it might be hard to write regulations for customized derivatives -- especially since we can expect that their creators are sure to "customize" them in ways that would help them avoid any regulations Treasury might write. On the other hand, I don't understand why they can't be sold like other securities -- in an open market, with full disclosure.

The pivotal word in that last sentence, in case you didn't notice the double emphasis, is "can't." Clearly, they can be sold like other securities -- the only problem being that the profit margins of the originating banks would be sharply reduced. Well, we "can't" let that happen, now -- can we?

Hey! Obama! Yes we can!

Regulation and the Free Market

Just in case you haven't noticed yet, Friedman and Greenspan were wrong. Free markets are extremely fragile. Left untended and unregulated, they can't survive -- they succumb to what economists call "market failure." The only institutions powerful enough to prevent market failure are governments, and the only way they have to do that is through economic regulation.

The chief component of the market failure that created our current economic crisis was lack of information. For markets to operate properly, buyers and sellers must be aware of the real value of what they buy and sell. In the case of derivatives, as we now know, that information just wasn't available. Not only were buyers misled by the ratings agencies -- who were paid by the sellers -- but derivative sales were private. Buyers had no means of knowing what other buyers were paying for very similar instruments. The derivatives market was totally obscure, and totally unregulated.

"Then, let there be regulation," intones Obama. "Right on it, boss," cries His Boy In Treasury, Timmy G. And there shall be regulation. Effective regulation? Um, well...

Some Democrats in Congress, like Senator Tom Harkin (whom I recall supporting in a presidential primary a great many years ago), want all derivatives to be traded in an open exchange -- like stocks or commodities. That would provide full transparency, and make a repeat performance of the current mess just about impossible.

Timmy G. has another idea, though -- derivatives would be traded through privately managed "clearinghouses," which would make the trades, well, sort of semi-transparent. More complicated, "customized" securities, however -- like the credit default swaps that brought down AIG -- would remain outside the system, and totally opaque.

You get one guess: which plan does the industry prefer? Here's a hint: if buyers get to know what the securities really are worth, they won't pay as much for them.

Maybe Obama will surprise me, and get behind the idea of an open exchange. Somehow, though, I doubt it. Bill Clinton signed the December 2000 bill exempting most derivatives from regulatory oversight, and so can claim a fat share of the responsibility for our current problems. Barack Obama, who took even more in campaign contributions from the financial industry than Clinton did, is not likely to be a major improvement.

As Dick Durbin pointed out recently, "the banks ... are still the most powerful lobby on Capitol Hill. And they frankly own the place." I'm afraid that probably is true of the White House as well.

Well, so much for free markets. How can markets be free when the government that's supposed to protect them is bought and paid for?

The next bank bailout

It's Saturday. Geithner won't give his speech until Monday, and who knows how much he'll be willing to lay on the table even then? I figure it is incumbent upon me to speculate a bit, so that, as events develop, my forecasting ability may be evaluated. (By the way, I never go back to edit earlier postings -- except for obvious typos.)

And, so, it looks like what will be announced Monday could be a fairly clever compromise. Instead of "sin eating" Wall Street's toxic assets, government will invite private investors to buy them -- but with reduced risk because of government insurance. In essence, the Treasury would be issuing credit default swaps.

If done right, it could work. The only way to get a fix on what all those "troubled assets" are worth is to get people buying and selling them again -- but will it be done right? That remains to be seen.

To my mind, doing it right involves a few basic rules. First, no asset should be insured for more than half of what the investor pays for it. Insuring assets for full "face value" is the same as buying them outright, except without the opportunity to sell them if their value increases.

Second, pre-existing credit default swaps should not be re-insured. Since the lion's share of those were sold to buyers who did not even own the securities they supposedly insured, covering them is tantamount to insuring gambling losses.

Third, government should charge a fee for the insurance it issues. Investors were willing to pay for credit default swaps in the past, and they still should be willing to do so -- especially since the insurance is being issued by government, an institution which will not default.

Fourth, participating banks should be required to write down the alleged value of all derivatives that do not find buyers in a reasonable period of time. Only in that way can we discover which banks are essentially healthy and which are among the walking dead.