Mar 13

Bravo, Chairman Gensler!

Posted by Kristjan Velbri | Posted in Financial Regulation | Posted on 13-03-2010

Gary GenslerChairman of the CFTC, Gary Gensler has really grabbed the bull by its horns – he is proposing wide-ranging reform of the over the counter derivatives market, with a special focus on credit default swaps. I understand that for some of you this might look like gibberish, but it is important to understand that derivatives played an important role in the credit crisis (see this link for explanation). Without credit default swaps, AIG wouldn’t have needed a bailout. Lehman would not have failed, were it not for their huge (off-balance sheet) position in mortgage derivatives such as CDOs and synthetic CDSs.

Here are some excerpts from Mr. Gensler’s speech, the full version of which can be downloaded here: Keynote Address of Chairman Gary Gensler, OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference. All highlights are my own.

The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story. They were at the core of the $180 billion bailout of AIG. The reliance on CDS, enabled by the Basel II capital accords, allowed many banks to lower regulatory capital requirements to what proved to be dangerously low levels. They also contributed to weak underwriting standards, particularly for asset securitizations, when investors and Wall Street allowed CDS to stand in for prudent credit analysis.

Mr. Gensler goes on to talk about reform:

Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Here, Mr. Gensler makes an excellent point regarding the right to buy insurance. It is not known to many that credit default swaps can be bough ‘naked’, that is, you can buy insurance on an institution that you don’t even have stake in. That would be like buying fire insurance on your neighbor’s house -  it doesn’t take a college degree to figure out what happens next to the house in question. Mr. Gensler:

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

Hat tip: Barry Ritholtz
Image courtesy Businessweek.

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Dec 15

House Thinking About Glass-Steagall

Posted by Kristjan Velbri | Posted in Financial Regulation | Posted on 15-12-2009

From Bloomberg:

The U.S. House is considering reinstituting the Depression-era Glass-Steagall Act, which barred bank holding companies from owning other financial companies, Majority Leader Steny Hoyer said today.  A renewal of the 1933 law “is certainly under discussion” by House members, Hoyer, a Maryland Democrat, told reporters in Washington. The Glass-Steagall law was repealed in 1999 to help pave the way for the formation of Citigroup Inc. by the $46 billion merger of Citicorp and Travelers Group Inc.

Glass-Steagall was the law that kept commercial banks (the likes of Bank of America before its purchase of Merrill) and investment banking separate. It was intended to stabilize the banking system and is served its purpose for over 60 years until 1999, when it was repealed by the Gramm-Leach-Bliley Act. The latter is what got many banks into trouble in the current financial crisis. When the Glass-Steagall Act was first instated, it was done to stabilize the banking system that had failed after the crash of 1929. It was only the Great Depression that got politicians thinking. Out of it, the SEC was born. But the formation of SEC came with a lot of new regulations, regulations that investors and traders these days consider to be vital. Mandatory reporting is one of them – before the financial reform of the 30s, companies didn’t have the obligation to report quarterly or even yearly transactions. There was no obligation to disclose insider ownership or even the number of outstanding shares, for that matter. Glass-Steagall was one of the cornerstones of these reforms and the US has to reinstate it, for the sake of its trustworthiness, but also for the sake of the banking system as a whole.

Phil Gramm, the former Republican Senator from Texas who co-wrote the act that undid Glass-Steagall:

I’ve never seen any evidence to substantiate any claim that this current financial crisis had anything to do with Gramm-Leach-Bliley. In fact, you couldn’t have had the assisted takeovers you had. More institutions would have failed.

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Nov 22

Goldman Sachs CEO: “We are doing God’s Work”

Posted by Kristjan Velbri | Posted in Finance | Posted on 22-11-2009

Really? REALLY??!! Stealing from the American public is now called God’s work? These guys can’t be serious. But that was not all. This outrageous claim was later followed by another statement:

We participated in things that were clearly wrong and have reason to regret,” Blankfein, 55, said at a conference in New York hosted by the Directorship magazine. “We apologize.”(source)

What exactly did you have in mind when you said that you “participated in things that were clearly wrong”? Would you care to specify? What about stealing billions of dollars from the American public via your accomplices at the Treasury Department and the New York Fed? This is clearly not a ‘mistake’, this is fraud and should be prosecuted as such. And where is the SEC and the DOJ? Why aren’t they doing anything about it? Recent media reports have been pretty clear about the fraud involved in the bailout of AIG, of which Goldman was a beneficiary to the tune of $12.9 billion (sic!). Last but not least, this ‘apology’ was not accompanied by a promise not to repeat these ‘mistakes’ again.

This statement was accompanied by a promise to give small businesses $500 million dollars in loans to help them recover from the recession. Of course, they left out the part where it says that it’s actually government money that they’re ever so willingly loaning out:

“Goldman Sachs repaid the $10 billion it was given last year under the taxpayer-funded Troubled Asset Relief Program, plus dividends. The firm continues to benefit from federal guarantees on about $21 billion of long-term debt.“(source)

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Nov 19

What Does Bill Gross Think?

Posted by Kristjan Velbri | Posted in Economy, Finance, Markets | Posted on 19-11-2009

This is from Bill Gross’s Investment Outlook for the month of December, published this morning. I recommend reading the entire article, but here is the punchline:

“…before moving on, let me state the obvious, but often forgotten bold-face fact: The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until.”

Mr. Gross publishes his Investment Outlook every month and it is always a worthwhile read. Sometimes his letters seem sort of like stating the obvious, but that is actually not a bad thing. Mr. Gross works for PIMCO, which is said to be the biggest bond fund in the world. The people at PIMCO are as professional as you can get – people all around the world would pay thousands, and indeed they do, to get some idea of what people like Bill Gross, Warren Buffet and Marc Faber think about the markets and the economy*. They’ve been in this business far longer than most investors and as a consequence, they know more and it pays to listen to what they’ve got to say.

You can sign up for e-mail updates. In addition, there are other contributors worth reading at PIMCO – check them out!

*These three names are just an example, they are by no means the only geniuses out there.

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Sep 05

Special Drawing Rights: Not a Solution

Posted by Kristjan Velbri | Posted in Finance, Politics | Posted on 05-09-2009

During the years that preceded the current crisis, the American economy was booming. But it was not real economic growth for the money that was lent was not spent on investments but on real estate and consumer goods. Now that the bubble has burst, the Unites States administration has decided that the economy needs “stimulation”. The US has been running a budget deficit for well over a decade but with the new stimulus, the cash for clunkers (don’t forget the new “cash for refrigerators”) and many other programs that are supposed to stimulate the consumer who is already dead on the floor, the budget deficit has reached an unprecedented 1.2 trillion dollars (that’s $1,200,000,000,000).

But the US is not the only one that is suffering from the crisis and so it has become difficult for the US Treasury to finance the multiple programs put forth by the administration and the Congress. But where there is a need, there is a solution. The US “solved” the problem of financing with quantitative easing, which in English would means more like “printing money out of thin air”. Of course, once you start printing more money, you decrease its purchasing power. Since the US dollar is the predominant reserve currency of the world, it is easy to see why it makes so many politicians uneasy:

…Malaysian human-rights activist; a Filipino congressman; Zhou Xiaochuan, the head of China’s central bank; and French President Nicolas Sarkozy.

For each of them, the dollar’s role as the world’s so-called reserve currency presents inherent economic instabilities, with dangerous consequences. In both the run-up to the crisis and the crisis itself, an obsession with holding dollars roiled economies around the world. Today, those foreign countries are fearful of dollar inflation, which could decapitate their own bank reserves.[1]

Special Drawing Rights are not a real solution

For months now, political leaders from around the world have been drawing attention to the lack of discipline of the Federal Reserve. Some have even gone to the IMF and purchased special drawing rights (SDRs), the wannabe currency of the IMF. The media has been all over the issue, claiming that this is a real threat to the dollar, when it actually isn’t. Let’s take a closer look at it.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).[2]

What are these four key international currencies? Could it be that the dollar is one of them?
The percentages of the currencies that make up the SDRs are listed below? Can you guess which one of them is the US dollar? You only get one try, though.
*1st currency 44%
*2nd currency 34%
*3rd & 4th currency, each 11%

Buying special drawing rights to diversify out of the dollar makes no sense because for each dollar you get 44 cents back in the dollar, and just 56 cents back in other currencies. But because the dollar is the reserve currency of the world, the percentage is actually higher than that. Most currencies around the world are backed by other currencies or foreign debt, most of which is denominated in the US dollar. So buying special drawing rights is just a political and economic statement, but nothing more. If a central bank would want to diversify out of the dollar it would not buy special drawing rights, it would most likely buy gold or government debt from Australia, Canada and other countries whose economies are heavily linked to commodities, or in other words, insulated from dollar inflation. In fact, the same countries that have been buying SDRs or have expressed their interest in doing so, have also been active in the gold market. The Russian central bank and the Chinese alike have been hoarding gold, the latter has also been active in the silver market by publicly announcing silver bullion sales for investment purposes on its national TV (remember, anything that is on national TV in China has been previously approved). Whatever talk there is about special drawing rights, always look past the headline and see if there are real signs of diversification.

Special drawing rights purchases are a statement, gold purchases are a materialization of that statement.

1. Quoted from the Wall Street Journal: Inevitable End to Dollar’s Reserve Role
2. Definition from the IMF

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