Sunday, July 19, 2009
Derivatives Spread Risk?
"Since it is chillingly clear that US financial institutions have for a good while been regulated no more stringently than, say, demolition derby drivers, Washington has belatedly locked the garage door and begun to debate strict new rules. ... A basic reason for favoring regulation is that derivatives create a kind of mirage. They don't extinguish risk, they simply transfer it to a third party--a counterparty, as the term goes. ... Roughly a year later , there was a rash of derivatives problems that punished companies like Proctor & Gamble and American Greetings and supported the notion that most nonfinancial CEOs didn't have a clue about the intricacies of these instruments. ... Robert Steel, a ranking member of Henry 'Hank' Paulson's US Treasury team, remembers the case against a rescue: 'Gee whiz, this isn't a depository institution. It should just go out of business.' ... Derivatives, in other words, had changed Bear from a broker-dealer that could have been simply the latest name on a Wall Street tombstone to an entity that the government needed to save because it was too interconnected to fail. ... The feds essentially decided at this point that it was better to save AIG than to risk a domino effect among its counterparties, which were about two dozen prominent financial institutions in North America and Europe. ... But the Lehman saga illustrates another toxic aspect of derivatives: They are often a mess to value. That can lead, intentionally or not, to misreported profits and assets. ... But within two weeks of the bankruptcy filing, BofA sued Lehman to recover the $357 million, saying that Lehman in fact owed derivatives payments to BofA. Ultimately BofA placed the amount it was owed at $1.95 billion! In other words, by BofA's thinking, Lehman didn't have a plus of $357 million, but rather a minus of $1.95 billion. ... Considering the unending complications of derivatives, wouldn't we be better off without them? ... 'It doesn't matter what they do in Washington,' said a New York derivatives trader recently, showing Wall Street's all too common contempt for policymakers. 'The smart guys who come out of business school don't take regulatory jobs there. The smart guys go to places where there are chances to do well. And if there are new rules, the smart guys will just deal with them and move ahead'," original italics, my emphasis, Carol Loomis at Fortune, 6 July 2009.
If "smart guys" start getting long prison terms for peddling this "financial crack", they will stop. No regulation will work as well as prison terms which smart guys can't "diversify" out of. Derivatives "don't extinguish risk ... they simply transfer it". This is key. We can use this concept to kill them. Have derivative accounting conformed at issuance and quarterly. If A says the derivative is worth $1 million, counterparty B agrees, or else the contract is closed and its value arbitrated. If A or B can't pay, it goes bankrupt. Period. Yes Steel, Bear wasn't a "depository institution". It should have gone bankrupt. I would prohibit depository institutions from dealing in derivatives. To hell with AIG's counterparties. Why bail out Lloyd Blankfein (LB)? Just because Henry Paulson is a Goldman alumus? LB has enough money, he doesn't need Joe Schmoe's. Yes, "derivatives are often a mess to value". That's one reason bank accounting stinks. I see financial statements with model derived derivative values that I believe no one would pay to buy the instrument. They look like fiction to me.