Derivatives and Toothless Regulation

Andy Xie, writing for Caijing in early June, provided a timely warning for those attached to the recent market rally.

The Washington Post reports regulators have reached a general agreement on handling derivatives, but reveals that the administration is still woefully ignorant of the problems at hand.  To wit,

Non-standard derivatives would be exempt from much of this regulation. These are derivatives linked to highly complex investments, such as securities composed of mortgages and other kinds of debt.

Broad Agreement Reached on Derivative Oversight, 2009-06-23

The word “complex” has been overused of late, just like the phrases “cash-strapped” and “unforeseeable”.  It often appears when a reporter has encountered a concept requiring more than five minutes to explain and is thus beyond their understanding.  Presumably it is also beyond the understanding of the reader, an assumption that likely holds in the general case but does a disservice to those members of the population retaining some minor cognitive ability.  (I am unnecessarily harsh to Mr. Goldfarb, the reporter of this piece, but the opening was given.  Other articles are far more deserving.)

In this case, however, the adage regarding investments that cannot be suitably explained in less that five minutes holds particularly true.  Christopher Whalen, in yesterday’s testimony to the Senate Subcommittee on Securities, Insurance, and Investment, provides an excellent summary of the exploitable inefficiencies of the OTC derivatives market.

In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

– Christopher Whalen, 2009-06-22

Mr. Whalen’s opinion is no doubt influenced by his encounters with past fraudulent practices, specifically the use of side letters in reinsurance scams.  In another article, conveniently appended to the above linked testimony, he provides some history of these practices.  His suggestion that AIG moved into the CDS industry as a result of greater law enforcement awareness of such side letters may not be without merit, and is certainly deserving of thorough investigation.  (In this context a side letter, or email in these more modern times, is a secret agreement between two parties that effectively nullifies a public agreement.  This allows a company to mislead regulators and the public about its capitalization.)

Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts.

Short Updates

A few items on my mind, deserving of note:

  • Goldman’s Cohen’s touting a 1050 target on the S&P.  While once a perfectly reasonably number for a bear market rally, I now almost feel compelled to load up on puts.  (And would not be particularly surprised to learn that Goldman’s trading desk was doing the same.)
  • The behavior of the administration (past and present) in strong-arming investors into making poor decisions in an attempt to continue papering over gaping wounds in the financial system.  Bernanke and Paulson’s threats to Ken Lewis of Bank of America are the largest example, though rumor has it such pressure was also applied in an attempt to avoid a Chrysler bankruptcy.
  • Also, I hear more than a few comments of the “now is the time to buy” sort.  This should also be addressed in a full post, but my position still remains that we are looking at a deflationary severe recession or depression.  In short, I expect further significant declines (30-50%) in both housing (Case-Shiller) and equity (S&P 500) indices.


In an interview with ABC News’ Terry Moran, President Obama made a few comments about nationalization.

 MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?

OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obama: No ‘Easy Out’ for Wall Street, 2009-02-10

On the face of it, we have two paths, one right and one wrong.  Tradition apparently dictates the wrong one.  I say tradition, because while this country has thousands of banks, many are healthy.  As Kedrosky notes, that objection ignores the relative GDPs of the two countries as well as the fact that the six largest banks represent the lion’s share of the problem.

It is possible Obama does not feel there is sufficient political support for nationalization, and so will run with the current plan until attitudes are more favorable.  I acknowledge that this is only conjecture, but feel it appropriate to ascribe some measure of strategic planning to this administration.

Poor GDP Numbers

Citigroup (remember, the ‘c’ is pronounced ‘sh’) just announced it raised $12 billion in an FDIC-backed bond sale.  Freddie Mac will request $35 billion from the Treasury, subject to change as it finalizes its financial statements.

China and the UK are boldly heading over a cliff; the headline 1.5% Q4 GDP decline for the UK is not annualized, and thus corresponds to a 6% drop using the American reckoning.  Similarly for China, the reported 6.8% Q4 GDP growth is zero or negative using the seasonally adjusted at an annual rate (SAAR) method.  Other data for China, e.g. a 7.9% y-o-y drop in electrical production, help confirm this.

Given that many consider the bond market a refuge in time of poor equity performance, I’d like to point out that most funds do not fall into the “cash or short term treasurys” category that I currently consider safe.  This may become especially relevant later this year.

Problems With The Chicago School

Barry Ritholtz rips into the Chicago School:

 From the efficient-market theories, to the concept of man as rational profit maximizers, much of the edifice that is was the Chicago school of economics is based on a foundation that is false, disproven or otherwise questionable.

…and is aided in the comments section:

“The ONLY thing wrong with the Chicago School of economic thought, and Friedman’s belief that free markets allocate resources better than any alternative, is that they do not allow for the influence of corruption, fraud and greed.”

In other words, they do not allow for reality. Curious that Ayn Rand also embraced lack of reality, creating a fictional world upon which to foist her ficticious philosophy. Strauss, too, was guilty of this type intellectualized magical thinking.

The need for fictionalization is explained by the realization that only by ignoring human behavior and controlling outcomes can the extremist’s view be proven valid.

-Winston Munn