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Explaining FinReg: Derivatives

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I've been dreading this one. Derivatives are rough sledding. Explaining futures, options and swaps is the blogger's version of the Oregon Trail: It'll take months, and you'll probably lose most of your people along the way. Maybe to dysentery (but maybe not). But you have to get into it: If we don't get derivative reform right, FinReg isn't worth the paper it's printed on.

Here's the good news: You don't need to understand the different types of derivatives. All you really need to know is that financial firms trade derivatives, they're worth an extraordinary amount and there's a category of them that's almost totally unregulated. That's a big part of the reason why the financial crisis was as severe as it was: We had no idea how many derivative contracts these major firms had with each other -- and with everyone else. So when Lehman fell and other banks threatened to follow, no one could predict the consequences. "What we mean when we say a company is 'too big to fail,'" says the Roosevelt Institute's Mike Konczal, "is that they have too much derivative exposure too fail."

So, derivatives: bets that other firms have with one another and that are big enough to crash the financial system if a firm defaults, but not bets that we know about or regulate. That's not so hard, right?

And that's the end of the derivatives lesson for the day. The concept you really have to know about isn't derivatives, but the answer to the derivatives problem: The clearinghouse. First, here's a graphic that won't make sense for a minute but will be useful while reading the next few paragraphs:

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Right now, these trades are made bilaterally. That is to say, I make a deal with you for a price that we both agree on. AIG demonstrates the problem with that strategy: One of us might sign more of these deals than we can actually afford if the bets don't go our way.

The clearinghouse solves that problem. It stands between me and you and manages our bet. So when we make a deal, we'd both have to post up some initial money to the clearinghouse. And we have to update that money every day. The trade is "marked to market," which is to say, it's evaluated based on what would happen if it had to be settled today. Whoever lost ground that day has to post more money to the clearinghouse. And all participants have to give the clearinghouse a bit more money beyond that in order to make doubly sure the clearinghouse can pay the bets back.

This does a couple of things. First, it means we know who has bets with whom. Rather than a web of derivatives, it's a map. Second, it means we know everyone can pay off their bets, and we can see if one firm or another is suddenly taking massive hits every day. There would be no AIG-like situation, where they seemed to be doing fine and then, all of a sudden, seemed about to blow up the financial system. We would've watched the wave build rather than only noticing when it was breaking atop us.

So that's the first, and most important, step. The second piece of the puzzle is exchanges. Stocks are traded on exchanges. So are some derivatives. The upside of an exchange is that it creates pricing transparency. If you and me make a deal and don't tell anyone about it, no one knows the price. That's fine for you and me, of course, but what we saw in the financial sector was that we had trillions in derivatives that we couldn't price. Figuring out a price, in fact, was the whole point of Tim Geithner's Public-Private Investment Partnership program.

Wall Street doesn't want exchange-trading because, well, it will reduce their profits. They can skim much more off the top if they're negotiating one-on-one than if they're in a competitive market where everyone can see prices. It's the difference between shopping in a flea market and shopping on Amazon.

The other major policy proposal is Blanche Lincoln's effort to spin the parts of banks that trade these derivatives off from the rest of the bank (at least if the bank wants access to the Federal Reserve's low rates). So rather than there being a Bank of America that trades credit default swaps and holds your deposits, there would be a Bank of America that held your deposits and a BofA spin-off that traded derivatives. Experts I spoke to were split on this, with some saying it's a smart move to break apart the risky parts of banks from the commercial deposit divisions but more saying that it's unnecessary and likely to create a lot of disruption in a fragile economy.

The hiccup in all this is what's called "the end-user exemption." There are two types of folks who use derivatives: Companies who are legitimately hedging future risks (say, an airline that's worried about the price of fuel in 2015) and firms -- and sometimes companies -- that are just trying to speculate. The legitimate hedgers don't necessarily need to be regulated in the same way the speculators do. The trick is writing that exemption narrowly enough that speculators can't slip through the door as well.

An important note to all this: Unlike most of financial reform, which is really about changing the powers of regulators, this is really a reform of how Wall Street conducts its business. It is, in other words, "Wall Street reform," which is the term Democrats prefer to use. And if the end-user exemption remains limited, and clearinghouse and exchanges become the norm, we're in pretty good shape: Clearinghouses will take care of the main risks derivatives pose to the system. Exchanges will allow us to price the products and detect movements in the market. Get this right, and financial reform might just work. Get it wrong, and it definitely won't.

Graph credit: Cantwell office.

By Ezra Klein  |  April 22, 2010; 3:26 PM ET
Categories:  Explaining financial regulation  
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Comments

"There are two types of folks who use derivatives: Companies who are legitimately hedging future risks (say, an airline that's worried about the price of fuel in 2015)"

So, why would that airline care about derivatives being traded through a public exchange? It would seem that only the speculators would want the "end user exemption", and that the folks legitimately hedging as a form of insurance wouldn't need an exemption, per se.

"Experts I spoke to were split on this, with some saying it's a smart move to break apart the risky parts of banks from the commercial deposit divisions but more saying that it's unnecessary and likely to create a lot of disruption in a fragile economy"

I think some disruption is necessary, if the goal is to actually improve circumstances.

Posted by: Kevin_Willis | April 22, 2010 4:08 PM | Report abuse

"Explaining futures, options and swaps is the blogger's version of the Oregon Trail: It'll take months, and you'll probably lose most of your people along the way"

about 500,000 people made it across the oregon trail.
about 10 percent didnt make it.
we can do this!!!!

"Many accidents marred the trip west. Do we know who any of the first accident victims were?

We know at least the following: Joel Hembree (six years old) was the first to be killed on the Oregon Trail by being run over by a wagon. ["July 18-A very bad road. Joel J. Hembree son Joel fel off the waggeon tung & both wheels run over him. July 19-Lay buy Joel Hembree departed this life about 2 oclock." [William Thompson Newby's Diary of the Emigration of 1843." P. 3, entries for July 18 and July 19.]"

Posted by: jkaren | April 22, 2010 4:12 PM | Report abuse

Ezra, this sounds an awful lot like the difference between a bet on a sports game between friends (bilateral) and with a bookie (central counterparty). Why do you want to go from friends being friends to making the government into the mafia?!

Posted by: MosBen | April 22, 2010 4:13 PM | Report abuse

Kevin is spot on, in my opinion. Why sould legitimate hedgers NOT want their hedges on an exchange?

If I were hedging I'd want to know I'm not being over charged and that the contract I'm purchasing is what it is supposed to be. An exchange helps insure that.

And financial experts that are worried about market disruptions so soon after financial experts darn near destroyed the global economy? Really?

Posted by: nisleib | April 22, 2010 4:22 PM | Report abuse

Ezra, to help “concentrate the mind” in next week’s Senate debate on FinReg, might I suggest that you research, conduct a gedanken experiment, and write on the expected option-ARM default tsunami [1].

Option-ARMS were funded were funded from 2005 to 2007, and although represent less than 2 percent of all home loans, they carry a total balance of nearly $300 billion. (Unlike subprime mortgages reset after 2 years, option-ARMS reset after 5 years [like starting in 2010]).

Of that total balance 60% are in California where home prices have fallen 30-40%, disqualifying borrowers from MakingHomesAffordable home loan modification.

Question: Do the regulators know where all this option-ARM mortgages and their CDO derivatives are?

So getting back to your post, a derivatives clearinghouse in 2005 to 2007 would be tremendously helpful now.

Maybe in addition to a derivatives clearing house we need an emergency registration?

For example did AIG insure option-ARM CDO paper? If all this stuff is on say Goldman Sach’s balance sheet, given the “gift” from the government of spread interest income, why are the banks paying out so much bonuses when instead they should be reserving for this option-ARM default tsunami.

[1] See, e.g., “Option ARMs pose threat to housing market,” Los Angeles Times, March 20, 2010.

Also “Option-Arm Loans Add to Shadow Inventory,” Kimberly's US Economy Blog, April 18, 2010.

Posted by: msa_intp | April 22, 2010 4:46 PM | Report abuse

I would guess legitimate hedgers want the exemption so that they don't have to post collateral. Derivatives are volatile, and could potentially tie up a good chunk of cash that legitimate businesses need.

Besides, if you're really using derivatives to hedge, you'll always have enough money to pay off what you owe (gains will cancel out losses). It's only the speculators that can really get into trouble.

Posted by: jsrice | April 22, 2010 5:01 PM | Report abuse

A clearing house concentrates the counterparty risk into itself by stepping in between the contracts of two clearing firms. It enforces the marking to market (or netting), collateral deposits, and has bailout funds in case any of the clearing firms fail to net.

A clearing house hasn't failed in a long time, but that doesn't mean they can't. It must manage its net exposures and enforce netting and collateral calls. A shock could force one to fail. Yvez Smith recounts one example of a near-catastrophe (near-miss?) in the link below.

Sources:
http://en.wikipedia.org/wiki/Clearing_house_%28finance%29

http://www.nakedcapitalism.com/2009/11/the-fantasy-of-the-clearing-house-magic-bullet.html

Posted by: rglvr | April 22, 2010 5:15 PM | Report abuse

I appreciate that you made the distinction between centralized trading and central clearing.

I think a point to be emphasized in your discussion of clearinghouses is that the ease with which clearing is implemented is related to the design of the securities being traded. It's simpler to establish clearinghouses when standard contracts are supplied and demanded by large pools of natural longs and shorts.

If derivatives with the flavor of CDS are to be centrally-cleared, it's likely to require some innovation in security design, in the direction of more standardized contracts with exposure to default risk. This argument extends to other customized derivative contracts currently traded on over-the-counter-markets.

Posted by: nmph | April 22, 2010 8:46 PM | Report abuse

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