>H.R. 4173: Looking Backward

>Now that the House has passed H.R. 4173, the Consumer Financial Protection Act of 2009, inclusions on the regulation of Swap Markets, this is as good a day as any to review some of the basic problems the bill is supposed to fix.

Swapping Swaybacked Horses In Mid Stream

This might be a good time to revert to the standard definition of a swap as it was before the little wizards on Wall Street started getting “creative” with them. Once upon a time a swap meant the exchange (trade or substitution) of one security for another including currency swaps, or interest rate swaps. Investopedia described an old fashioned swap in which one corporation had a fixed interest rate while another corporation had access to a floating interest rate. “To take advantage of this situation, the companies would do an interest rate swap.” Why? Because corporations doing business in more than one country want to protect themselves from big swings in currency exchange rates or interest rates. How? In an interest rate swap, for example, each party pays the other at set intervals over the life of the swap. One may pay a 3.5% interest rate, while the second party might agree to pay LIBOR+0.5% over the same value. [FinDict] There’s nothing nefarious here, trading interest rates could actually help a company use swaps to upgrade the quality of its investments, realize a capital loss for tax purposes by selling securities that have degraded in value, or protect itself from wild variations in currency exchange rates or interest rates. In this context, the swaps are used for risk management.

Sometimes A Great Notional Value

There’s another headache producing term that requires some explanation: Notional value. Our corporations in the preceding paragraph were swapping in order to manage the risk involved in their international trade, to prevent getting whacked if interest rates in one country or another started bouncing up (or down). Each party was paying “at set intervals” over the life of the swap on the same notional value. What? Notional value is: “The total value of a leveraged position’s assets. This term is used commonly in the options, futures, and currency markets to describe how a very small amount of invested money can control a large position (and have a large consequence for the trader).” [FinDict] Here’s where the going got sticky — “a small amount of money controlling a large position.”

Investopedia offers an example: “As an example, one S&P 500 Index futures contract obligates the buyer for 250 units of the S&P 500 Index. If the index is trading at $1,000, the futures contract is the equivalent to investing $250,000 (250 × $1,000). Therefore, $250,000 is the notional value underlying the futures contract.” [FinDict] I think we can all figure out where this is going. If the notional value can be calculated like the S&P Index, since we can all look at the television set or check online to see the price of S&P Index trading, then life is good, the transaction has a predictable value. If, however, the swap is being made on something-anything-everything for which a notional value cannot be readily determined — oh, say something like the value of securitized asset vehicles sliced diced and tranched out of home mortgage paper — then what we have is not managed risk but layered risk.

The Edsel Rule

At some point in the trading frenzy of the early 21st century someone might have wanted to notice that The Edsel Rule should apply: Just because it is new doesn’t mean it’s an improvement. In culinary terms, just because you add some exotic ingredient to a dish doesn’t necessarily make the final product any better; expensive pepper won’t make for a better chocolate cake. However, not only was the Edsel Rule ignored, but the traders also forgot why the United States outlawed Bucket Shops in the early 20th century. Return with us now to those wonderful days of yesteryear (said the announcer on the Lone Ranger) as we enter the realm of Synthetic Credit Default Swaps.

Bringing Back The Buck Shops

Synthetic Credit Default Swaps are gambling. Nothing more nor less than “action in the financial casino.” These so-called synthetic or naked credit default swaps are pure gambling. “In the 19th century many American cities had what were known as bucket shops. A bucket shop had a New York Stock Exchange ticker and would post quotations as they came in. Rather than buy the stock, the customer bet on the tape—e.g., 20 shares of sugar at $100. The shop took a commission: If the stock went to $105, the shop paid; if it went down, the customer lost. Customers could also short a stock. Edwin Lefèvre’s 1923 classic Reminiscences of a Stock Operator vividly describes the turn-of-the century bucket shop. The shops were partially blamed for the Panic of 1907, and the states outlawed them shortly after that. Of course the New York Stock Exchange, where customers bought the underlying assets, continued to be legal.” [AmChron] Lovely.

So when the Commodity Futures Modernization Act passed in 2000, which pre-empted all regulation of bucket shops, the game was on. The immunizing statute was inserted into a spending bill — no members of Congress “had to be on record as voting for it.” [AmChron] Repealing the prohibition on Bucket Shops was supposed to be a wonderful thing. Over the counter (OTC) derivatives (swaps) was a highly lucrative market, the U.S. would be a “magnet for derivative business from around the world,” and we didn’t need to worry about what might happen to those Notional Values because as Lawrence Summers opined, “sophisticated investors” could be counted upon to take care of their own business. It wasn’t like they weren’t warned.

When Alan Greenspan took Brooksley Born to lunch in 1996 and had her for dinner

Like Cassandra tried to warn Agamemnon, Born, the head of the CFTC, tried to warn Greenspan and other de-regulation enthusiasts that what they were doing would cause systemic risk. What about a worst case scenario, the perpetration of fraud in these derivative markets, she asked Greenspan? “Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls him saying. Greenspan, Born says, believed the market would take care of itself.” [ABA] And, then the market took care of itself, with a big splat.

Chairing the CFTC, Born advocated reining in the huge and growing market for financial derivatives. De­rivatives get their name because the value is derived from fluctuations in, for example, interest rates or foreign exchange. They started out as ways for big cor­porations and banks to manage their risk across a range of investments. One type of derivative known as a credit-default swap has been a key contributor to the economy’s recent unraveling.” [ABA]

Cassandra was the first to see the body of her brother Hector brought back into Troy. Born, presumably was one of the first to see how those “sophisticated investors” behaved when allowed free rein under the Ayn Randian creations of Greenspan and his proteges. “The credit-default swap market—estimated at more than $45 trillion—helped fuel the mortgage boom, allowing lenders to spread their risk further and further, thus generating more and more loans. But because the swaps are not regulated, no one ensured that the parties were able to pay what they promised. When housing prices crashed, the loans also went south, and the massive debt obligations in the derivatives contracts wiped out banks unable to cover them.” [ABA]

Again, we should note, layered risk is not necessarily managed risk. When evaluating the efficacy of H.R. 4173 there are some basic questions that need to be set forth. (1) Does the legislation sufficiently address the capacity of “sophisticated investors” to misread their own markets? To continue to inflate their own bubbles without taking into consideration the pitfalls of over-leveraging and creating instruments of dubious notional value? (2) Does the legislation allow for the legitimate purposes for which swaps might be used without allowing the abuses about which Born was concerned? (3) Does the legislation define with some precision who can indulge in swaps trading and under what restrictions? And, (4) Does the legislation rid us of Bucket Shop operations?

DB will delve into these in future posts. Thank you for staying tuned in.

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