Thursday, April 17, 2008

Corrigan Group Redux (Institutional Risk Analytics)

Eventually, I believe, as do others, that over-the-counter derivatives such as credit default swaps will have to be cleared and settled through central clearing houses such as those used by the futures exchanges. For all the chicanery of speculators and hedgers on the exchanges, there have been no fears of contagion, of one participant's failure leading to others, of the sort that led to the Bear Stearns bail-out/ takeover/near collapse. Tragically, though, this would reduce the profitability of the banks' derivative businesses or, rather, the profitability in good times. In bad times, it would reduce potential or realised losses from counterparty risk. (John Dizard, Financial Times, 4/15/08)

News reports indicate that The Corrigan Group will be reconvening, led exclusively by representatives of the largest banks, to study the crisis affecting the financial markets. Limiting the participation in the Corrigan group solely to representatives of the largest banks almost ensures that the Group's recommendations will be entirely inadequate and irrelevant.

Back in June 2006, IRA co-founder Christopher Whalen interviewed his former boss, NY Fed President Gerald Corrigan, for an editorial in Barron's (See "A New Form for Risk Are these derivatives over-the-counter, or under it?," Barron's, June 5, 2006) regarding the counterparty risk inherent in OTC derivatives. At the time, the Goldman Sachs (NYSE:GS) risk honcho rejected the idea that OTC instruments like CDS eventually must be traded on exchanges in order to avoid precisely the systemic risk event which led to the failure of BSC earlier this year.

Two years ago, Corrigan argued that CDS must be traded OTC in order to ensure that clients can customize the structures to meet their particular needs. We disagree. Mandating an exchange-based market for CDS and other OTC derivatives would not preclude an OTC market entirely. But for the vast majority of investors, who simply need to be able to manage single name default risk via a liquid and transparent market instrument, an exchange traded CDS contract represents a huge improvement over today's deliberately inefficient markets. In particular, moving most of the volume in OTC derivatives contracts onto exchanges would eliminate much of the bilateral counterparty risk that killed BSC, almost killed Lehman Brothers (NYSE:LEH) now threatens Iceland and other nations in the global marketplace with systemic disaster.

Given that Corrigan has spent much of his professional life warning the financial markets about the systemic risks menacing institutions and markets, we find it inexplicable that he would ignore the lessons of the BSC debacle and continue to take a position which seems to us, at least, entirely retrograde. Obviously all of the major dealer firms benefit from the wider spreads and bigger profits in an OTC market structure, but at enormous risk. Does anybody really believe that the RAROC of being a dealer in OTC derivatives is positive?

Could it be that Corrigan's position at GS and that's firm's vested interest in the OTC status quo has clouded the vision of this dedicated public servant? No, we don't believe that. At the end of the day, we think Gerry Corrigan will put aside personal interest and do the right thing. But he may need some help.

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