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As the fight to pass legislation regulating financial derivatives heats up in Washington I propose that House Agriculture Committee Chairman Peterson and Senate Agriculture Committee Chairman Harkin consider naming their legislation the “Brooksley Born Act of 2009“. 

The executive branch and Congress made the wrong choices about regulating these products in 1998 and now as the global financial system tips towards depression Congress is again considering how to shackle this wild beast of a market.

Bloomberg reports on the near heroic efforts of Ms. Born to regulate this space during her tenure as Chair of the Commodity Futures Trading Commission (CFTC).

~~~~ “…. While leading the CFTC in 1998, Brooksley Born declared that the unregulated,  OTC derivative contracts could “pose grave dangers to our economy.’‘

Born, a lawyer who according to futures attorney Dan Roth battled fellow regulators with the ferocity of a courtroom litigator, lost a turf fight with Alan Greenspan and Robert Rubin over policing the deals.

After Congress exempted the contracts from U.S. oversight in 2000, the market swelled from about $100 trillion to $684 trillion by June 30.

The growth included credit-default swaps and collateralized debt obligations, custom-made products barely in use under Born’s reign. They played a part in almost $1 trillion of global bank losses and are prompting lawmakers to seek controls on the complex deals.

“Brooksley has been vindicated,” said John Tull, a CFTC commissioner from 1993 to 1999. “Had they listened to her, I think this catastrophe could have been averted.”~~~~

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I’m afraid that this debate will quickly devolve into techno-babble that will obscure the true issues of importance to the American people. Derivatives are very complex financial products and the trading,  clearing, and settlement of them is even more complex. The devil will dance in the details.

Introduction to credit default swaps (CDS)

(running time = approx. 7 minutes)

 
Over-the-counter, over the top from Marketplace on Vimeo.

Market size of CDS:

 This data is from the DTCC Trade Information Warehouse Data… and shows the volume of trades for last week.

Table 17: Single Name Reference Entity Type by Transaction Type

Market failures – AIG:

From the Wall Street Journal:

~~~~ ” … The government’s initial intervention was driven by concern that AIG’s failure to meet it obligations in the credit default swap market would create a global financial meltdown.

(A credit default swap, or CDS, is essentially an insurance policy on a bond acquired by investors to guard against default. AIG wrote tens of billions of dollars worth of these contracts.)

…Under the revised deal, AIG would transfer the troubled holdings into two separate entities that would be capitalized by the government…

… The agreements may be difficult to work out. Some financial institutions that face AIG in credit-default swaps don’t actually hold the physical securities on which they purchased protection. Merrill Lynch & Co., for example, previously sold many mortgage CDOs it underwrote to European banks.

Through a complex set of transactions, Merrill took back the credit risk of some of those assets and hedged that risk by buying credit-default swaps from AIG. When the securities fell in value, the European banks demanded collateral from Merrill which in turn demanded collateral from AIG….”

Market failures – Morgan Stanley:

From the Wall Street Journal… ~~~~ ” … On the morning of Sept. 17, David “Tiger” Williams, head of Williams Trading LLC, which offers trading services to hedge funds, heard from one of his traders that a fund had moved an $800 million trading account from Morgan Stanley to a rival. His trader, who was on the phone with the fund manager who moved the money, asked why. Morgan Stanley was going bankrupt, his client responded.

Pressed for details, the fund manager repeated the rumor about Deutsche Bank yanking a $25 billion credit line. Mr. Williams hit the phones. His market sources told him they thought the rumor false.

But damage already was being done. By 7:10 that morning, a Deutsche Bank trader was quoting a price of $750,000 to buy protection on $10 million of Morgan Stanley debt. At 10 a.m., Citigroup and other dealers were quoting prices of $890,000….

…The stock and (CDS) swaps trading were feeding on each other. That afternoon, Mr. Schorr, the UBS analyst, wrote: “Stop the insanity — we need a time out.”

In an interview that day, he said “the negative feedback loop of stocks and CDS making each other crazy shouldn’t be able to destroy the value of companies.”

Scrambling to stop the crisis of confidence, Mr. Mack phoned Paul Calello, investment-banking chief at Credit Suisse, and asked whether he knew what was driving the cost of the swaps up so quickly, say people familiar with the call. Mr. Calello said he didn’t.

Morgan Stanley’s chief legal officer, Gary Lynch, once the SEC’s enforcement chief, called New York Stock Exchange regulatory head Richard Ketchum. He said he was suspicious about manipulation of Morgan Stanley securities, and asked whether the NYSE would support a temporary ban on short selling, according to people familiar with the call.

Mr. Mack called SEC Chairman Christopher Cox, Treasury Secretary Henry Paulson and others. Trading in Morgan Stanley securities, he groused, was irrational and “outrageous,” and “there’s nothing to warrant this kind of reaction,” says a person familiar with the calls. The steps already taken by the SEC to prevent certain types of abusive short selling, he argued, didn’t go far enough….” ~~~~

Brooksley Born had it right in 1998… we are paying a high price for the interference of Robert Rubin , Aurthur Levitt and Alan Greenspan… the global losses may well amount to multiple trillions of dollars when this unwind reaches its end… I’ll write more about specifics of the legislative effort but it’s important that we keep our eye on the basics in this discussion… this vast unregulated market has concentrated and accelerated risk among large counterparties… the US taxpayer is already footing the bill for Goldman Sachs, Morgan Stanley, AIG bailouts… legislators cannot turn away this time… face the beast… tame the beast…