Wednesday, April 23, 2008

The jerry-built derivative structure will have to go

John Dizard - FT) Credit market people and their regulators have been so preoccupied with defusing the more visible unexploded bombs in Wall Street that the more serious, long-term structural problems have been put off for later attention. Much later attention, in the case of those structural problems that could cause career or biography damage for senior policy people.

The epicentre of all the problems is the financial system's dependence on over-the-counter derivative contracts, which made possible all the other bubbles that have been revealed and will be revealed soon. I believe that it will be necessary to dismantle carefully most of this jerry-built structure, and replace the bank-to-bank-to-dealer-to-dealer contract structure with central clearing houses for risk instruments.

Given that these are international markets of unimaginable size, this will take multilateral official co-operation to put into effect. The US government's involvement in the Bear Stearns work-out, far from marking the end of the credit crisis, shows how any resolution to the larger systemic issues will need to have official backing.

You will notice that through all the perturbations of the financial markets over the past nine months, there have been no problems with the operations of the centrally cleared futures and options exchanges.

The character and integrity of the participants in these exchanges - the speculators, hedgers and intermediaries - is no better than you would find in the over-the-counter markets. But the scope for wrongdoing is far less, since every day, every hour, these people's assets and liabilities are more or less accurately marked, and any deficiencies in their accounts have to be made up, or the accounts liquidated.

There were advantages of the over-the-counter markets for credit default swaps, interest rate swaps, and equity derivatives. OTC derivatives required less market-making capital than exchange-traded instruments, and the conserved capital could support more real economic activity.

OTC derivatives are more flexible than exchange-traded instruments, so they can be written for the exact requirements of the counterparties. That in turn made further capital savings possible, since (apparently) precisely hedged positions did not need the same level of reserves.

But it all got too big. The model did not take sufficient account of financial markets invariably taking any sensible innovation to senseless extremes.

I've been reading the Massachusetts state government's administrative complaint against Bear Stearns Asset Management, and its administration of the now bankrupt High Grade Structured Credit Strategies Fund, and the Enhanced Leverage Fund. The complaint has been filed in order to commence court proceedings against Bear Stearns.

No one can believe that Bear Stearns Asset Management was uniquely self-serving and careless; in fact, it may have been better than many of its counterparts on the Street. It's just that the poor behaviour of the Bear management is now a matter of public record.

There is some question as to whether state agencies, rather than US federal agencies, should have the authority for resolving these issues. In any case, the Massachusetts regulators have done a service in identifying a raft of systemic deficiencies in how derivatives risk and conflicts of interest are paid for by the investing public.

For example, according to the Massachusetts complaint, related party transactions were poorly administered. "The result of this poor conflict management was that hundreds of transactions did not obtain the approvals required by federal law and promised in the offering documents," the complaint claims.

Also, mis-priced derivatives instruments were allegedly transferred, or "novated" in the legal jargon, on the investors by Bear management. The transfers of value took place at cost rather than market value, the complaint claims, not to the advantage of the investors in the funds.

Referring to just two sets of transactions, the complaint says, "on information and belief, the net decrease in value to the funds as a result of the May 3 novation of credit default swaps . . . was $6,199,587 [and] . . . as a result of the May 8 novation of credit default swaps was $10,9111,290".

Multiply this sort of behaviour across the thousands of funds, vehicles, accounts and so on, around the world, and you see the scale of the problem. Exchange-traded and centrally cleared instruments may be less flexible and more capital intensive, but at least everyone sees the same prices.

How did this come to pass? Christopher Whalen of Institutional Risk Analytics blames the Federal Reserve and other regulators. "The Fed knows that banking is a commodity business, and by allowing the banks to migrate off the exchanges they allowed them to enhance their profitability. The Fed people knew risk management was a problem, but they thought they could deal with all the risks created by the over-the-counter model through the Basel 2 rules."

I guess not.

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