A new rule that would grant exemptions on swap trades

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Bill Haskell
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Here we are agin, trying to make it easier to trade derivatives. Never mind the lessons we thought we learned when Goldman Sachs called on AIG to ante up. There were little in reserve for the swaps and AIG was ready to collapse. Congress and the Fed (or reverse) saved them and the economy. The issue was Wall Street and Greenspan did not take swaps/derivatives seriously even after the Bankers Trust and Long-Term Capital Management. LTCM crisis – Extreme Events in Finance, extreme-events-finance.net.

Democrats Ask Biden Financial Regulator to Reverse Industry-Friendly Derivatives Policy, The American Prospect, Luke Goldstein

As taken from “Financial Regulator to Reverse Industry Friendly Derivatives Policy.”

Three Agriculture Committee senators want Rostin Behnam to drop a new rule that would grant exemptions on swap trades.

President Biden’s appointed chair of the Commodity Futures Trading Commission, Rostin Behnam, has taken up a new piece of financial deregulation first crafted under the Trump administration with the backing of Wall Street. The proposed rule would roll back Dodd-Frank protections for swap trades, a major class of derivatives that led directly to the 2008 financial crisis, by relaxing margin requirements for certain categories of investment funds.

There’s growing pushback on Capitol Hill to the proposed rule from Biden’s Democratic allies. Several members of the Senate Agriculture Committee, which oversees the CFTC, sent a letter today to Behnam urging him to drop the rule. Sens. John Fetterman (D-PA), Sherrod Brown (D-OH), and Tina Smith (D-MN) wrote . . .

“The Proposed Rule would be a step in the wrong direction and undermine the goals of Dodd-Frank.”

In October, Sen. Elizabeth Warren (D-MA) also sent a letter to the chair echoing similar concerns about the rule’s potential to create gaps in the regulatory framework put in place to safeguard the financial system after 2008.

AB: But now we have a background about Credit Default Swaps, the implications of them, the pennies on the dollar backing them up, the lack of a derivatives board monitoring the sale of CDS, the naked Credit Default swaps supposedly backing CDS up, and how one major company was called upon by Goldman Sachs to ante up. Why should we regulate CDS sways?

Robert Waldmann (2008) tells another portion of the collapse story.

Oddly no one mentions that the deal was great for Goldman Sachs, I guess that simple observation is too scurrilous for the Post.

I was interested in the discussion of what AIG did wrong.

AIG’s Financial Products division is the primary villain in the company’s free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk.

OK this is simple, there is risk that can’t be hedged by everyone. Someone has to bear aggregate risk. The idea that risk is a problem that can be solved, if one hedges rationally is, uhm, crazy. The idea of an insurance company buying insurance is odd. AIG uhm insures people, helps them hedge, bears risk (naked CDS).

In this case, AIG took on risk that they shouldn’t have taken on, but there is no reason to think that there was a rational equilibrium in which AIG wrote CDS and then hedged them by shorting the underlying assets.

One can make money by bearing risk or by outsmarting other people. Why would anyone expect an insurance company to be able to outsmart the financial services sector?

Someone somewhere on the web notes (without naming names) two eminent economists who said that the housing bubble wouldn’t be a huge problem as losses from bad mortgages would only be around $400 billion (similar to the losses when the dot com bubble burst) and the net value of derivatives is zero.

So, assuming people are rational, they will only have an unpleasant surprise similar to 2000.

However, if everyone thinks they are beating the market, because of their clever derivatives trading strategies, the moment of truth for derivatives (bankruptcy in the case of CDSs) will be a very painful shock. The fact that the total supply of derivatives is zero doesn’t mean that the total perceived expected value of derivatives positions is zero.

Similarly, if everyone thinks they have hedged aggregate risk by buying and selling derivatives, a mere $400 billion hit which people rated as hedged but it wasn’t can be much more damaging than a $400 billion hit which people knew they might bear.

The argument is that if everyone were rational except for the people writing mortgage contract, then everything will be more or less OK is true, but the hypothesis can’t be reconciled with the volume of trade in derivatives.

Alan Greenspan Testifying to Congress

Here is Alan Greenspan dancing around with his ideology. In the end of the back and forth, it was a “who would have thought moment.” Greenspan and others went to great lengths to block any chance of monitoring or regulating Swaps (think Brooksley Born). We will get to this towards the end. He never fully admits to being wrong.

REP. HENRY WAXMAN: The question I have for you is, you had an ideology, you had a belief that free, competitive — and this is your statement —

“I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We’ve tried regulation. None meaningfully worked.”

That was your quote. You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. And now our whole economy is paying its price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?

ALAN GREENSPAN: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to — to exist, you need an ideology. The question is whether it is accurate or not. And what I’m saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I’ve been very distressed by that fact.

REP. HENRY WAXMAN: You found a flaw in the reality . . .

ALAN GREENSPAN: Flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.

REP. HENRY WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?

ALAN GREENSPAN: That is — precisely. No, that’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.

JUDY WOODRUFF: When he was Fed chair, Greenspan made many appearances before congressional committees and was generally treated with deference. His opinion was widely sought and his words heeded.

But today, in the aftermath of the financial meltdown, Greenspan faced a much rougher reception from Democrats.

REP. DENNIS KUCINICH (D), Ohio: Ând Now, Mr. Greenspan, before the collapse of the housing bubble, didn’t you also say that the U.S. has not experienced housing slumps to justify your policy that there would be no bubble? And can you tell this committee when it occurred to you that there was a housing bubble?

ALAN GREENSPAN: I knew — the housing bubble became clear to me sometime in early 2006, in retrospect. I did not forecast a significant decline because we had never had a significant decline in prices. And it’s only as the process began to emerge that it became clear that we were about to have what essentially was a global decline in home prices.

After further questioning Alan Greenspan says this . . .

ALAN GREENSPAN: So it strikes me that, if you go back and ask yourself how in the early years anybody could realistically make a judgment as to what was ultimately going to happen to subprime, I think you’re asking more than anybody is capable of judging. And we have this extraordinarily complex global economy, which as everybody now realizes is very difficult to forecast in any considerable detail. And, Mr. Chairman, I know — I agree with you in the fact that there were a lot of people who raised issues about problems emerging, but there are always a lot of people raising issues, and half the time they’re wrong. And the question is, what do you do? I mean, you point out quite correctly that the Federal Reserve had as good an economic organization as exists, and I would say, in the world. If all those extraordinarily capable people were unable to foresee the development of this critical problem, which undoubtedly was the cause of the world problem with respect to mortgage-backed securities, I have to — I think we have to ask ourselves, why is that? And the answer is that we’re not smart enough as people. We just cannot see events that far in advance. And unless we can, it’s very difficult to look back and say, why didn’t we catch something?

One Person believed there was a danger to unregulated derivatives.

In 1998 CFTC chairperson Brooksley E. Born lobbied Congress and the President to give the CFTC oversight of ‘off-exchange markets’ for over-the-counter (OTC) derivatives in addition to its existing oversight of exchange-traded derivatives, but her warnings were opposed by other regulators.

Two actions by the CFTC in 1998 led some market participants to express concerns that the CFTC might modify the “Swap Exemption” and attempt to impose new regulations on the swaps market. First, in a February 1998 comment letter addressing the SEC’s “broker-dealer lite” proposal, the CFTC stated that the SEC’s proposal would create the potential for conflict with the Commodity Exchange Act (CEA) to the extent that certain OTC derivative instruments fall within the ambit of the CEA and are subject to the exclusive statutory authority of the CFTC.

In May 1998 the CFTC issued a ‘concept release’ requesting comment on whether regulation of OTC derivatives markets was appropriate and, if so, what form such regulation should take. Legislation enacted in 1999 at the request of the US Treasury, the Federal Reserve Board, and the SEC limited the CFTC’s rulemaking authority with respect to swaps and hybrid instruments until March 30, 1999, and froze the pre-existing legal status of swap agreements and hybrid instruments entered into in reliance on the ‘Swap Exemption’, the ‘Hybrid Instrument Rule’, the ‘Swap Policy Statement, or the ‘Hybrid Interpretation’.

The text of that act read: “…the Commission may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement”. Shortly after Congress had passed this legislation prohibiting CFTC from regulating derivatives, Born resigned. She later commented the failure of Long-Term Capital Management and the subsequent bailout as being indicative what she had been trying to prevent.

Much was made of Brooksley Born’s opposition to unregulated CDOs and CDS. There was supposed to be a Derivative Trades Board.

Some comments by those who opposed regulation of trades.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” Alan Greenspan

“I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post.

“My recollection was . . . this was done in a more strident way” … “characterized as being abrasive.” Arthur Levitt

Larry Summers testified to Congress that Born’s desire to regulate is “casting a shadow of regulatory uncertainty over an otherwise thriving market.“

Larry’s testimony set the stage for Congress to rein in the power of the Brooksley Born’s CFTC and the passage of Phil Gramm’s Financial Service Modernization Act of 1999 prohibiting the regulation of the derivatives market (In 2005, the revised bankruptcy laws would place derivatives outside of the laws also making it the first to receive compensation). W$ and banks had clear unregulated sailing in the sea of laissez faire in 2000 with a closing of the door for debtors in 2005. It was little better than a roach motel, you could check in but you can not check out.

AB: and Today? President Biden’s appointed chair of the Commodity Futures Trading Commission, Rostin Behnam, wants to release the Kraken on the marketplace thinking it is safe to do so. He has taken up a new piece of financial deregulation first crafted under the Trump administration with the backing of Wall Street. The proposed rule rolls back Dodd-Frank protections for swap trades, a major class of derivatives that led directly to the 2008 financial crisis, by relaxing margin requirements for certain categories of investment funds. Another, pennies on the dollar backing this garbage up.

Greenspan Admits ‘Flaw’ to Congress, Predicts More Economic Problems, Angry Bear, October 2023.

Bankruptcy law: Joe Biden vs. Elizabeth Warren, Vox, Matthew Yglesias, September 2019.

“The messenger wore a skirt,” says Marna Tucker, “Could Alan Greenspan take that?” Angry Bear, April 2013.

WaPo on AIG, Angry Bear, Robert Waldmann, November 2008

Remarks of Chairperson Brooksley Born on “The Lessons of Long-Term Capital Management L.P,” Commodities Law Institute on October 15, 1998 (cftc.gov)