Reports blaming Wall Street for helping Greece to hide its debt burdens with derivatives have the press and legislators jumping to inflammatory conclusions.
It's more than just the erroneous reporting that compares apples to bowling balls, that Goldman Sachs (GS) helped Greece snooker the European Union with currency swaps akin to credit default swaps sold by AIG or those taken out on Greece's debt.
Currency swaps are derivatives that rotate in and out of currencies. Credit default swaps are protection against a bond defaulting. Market columnist Felix Salmon and the Bond Girl have already dismantled these mistakes.
But the imbalanced reporting runs deeper than those errors and other mistakes, including that the default swaps on Greece's debt erroneously amounted to a colossal $85 billion, when the amount is actually a lot smaller, an estimated net notional $8.5 billion, after trades offset each other.
The continued lack of clarity doesn't help investors, corporations or other countries, and might actually serve to exacerbate, if not enable, Greece's troubles--including an inability to face up to its home-grown problems.
And worth noting, but largely MIA in the reporting, is the fact that AIG blew up because it had a microscopic capital cushion to support a balance sheet about the size of France, a balance sheet loaded with mindless trades.
(Footnote: US bank regulators probing derivatives trades on Europe's debt probably want to know who sits on the other side of these deals in order to try to avoid another taxpayer bailout.)
What's Missing in the Coverage
Also missing is the idea that the creaky "United States of Europe" doesn't like the cracks exposed in the coat of plaster it tossed on an always rickety monetary construct still in its infancy.
For anyone to think that the bonds sold by fiscal dipsomaniacs like Portugal, Italy, Ireland, Greece, Spain or Italy ought to have been trading at parity with Germany earlier this decade is breathtakingly absurd.
The swaps market started signaling this silly disconnect years ago. Fiscal boozers in Greece levered up the country to the breaking point, not Wall Street. AWOL in the reporting is the fact that Greece has been in violation of the EU's debt-to-GDP covenants for years. And the derivatives at stake are a fraction of the country's debtload.
MIA, too, is the point that government officials don't like it when the bond vigilantes exert the discipline they can't seem to muster as they try to own every business in sight, as in Greece, which owns businesses such as hotels, insurance companies, banks, ski resorts, notes Alpha Bank, the country's second largest bank.
And missing is the fact that derivatives can signal to smart investors that an inflated market is dangerously ballooning in any bond market.
Reporting Misses Regulatory Crackdown
The stories whiff on the fact that the U.S. and global regulators, as well as an entire industry, has already, and for some time now, moved to crack down on derivatives abuses which fueled the meltdown on Wall Street.
Specifically, bank regulators have already enacted and are moving to enforce reforms to better ensure market transparency, central clearing, standardization, and to force more collateral and capital cushions to support these trades.
Missing in the reporting is the fact that on March 1, the Federal Reserve Bank of New York published its fifth letter drafted and written in conjunction with the derivatives industry, global financial regulators from the G14 member countries, buyside institutions including banks and hedge funds, and trade associations.
Specifically, 42 Wall Street firms, hedge funds, top U.S. and international bank regulators pitched in.
The 42 includes the Federal Deposit Insurance Corp., the U.S. central bank, top bank and market regulators in France, Germany, Japan, Switzerland, the European Commission, the European Central Bank, JPMorgan Chase, Citigroup, Deutsche Bank, BlackRock and Bank of America, among others, who got the letter.
The Depository Trust Clearing Corp. and Markit Group, which publishes indices tracking a wide range of worldwide derivatives, are also on the stick.
Dismantling the NYTsParagraph by Paragraph
1.The NYT: “First came the news that Greece had entered into derivatives transactions with Goldman Sachs and other banks to hide its public debt.”
The trades are not news. Greece announced it was using derivatives back in 2001. Not reported here is that Nick Dunbar of Risk Magazine on Risk.Net was the first to give full ventilation to Goldman's derivatives deal in 2003.
Risk.Net reports that Eurostat, the auditing arm of the EU, knew Greece booked these derivatives as assets, not loans.
Should Greece have done a better job disclosing them? Yes. Did Goldman Sachs force Greece to enter into these contracts? No. Is Goldman operating on the ethical margins selling products that help governments hide debt? Yes.
2. The NYT: “Then came reports that some of those same banks and various hedge funds were using credit default swaps - the type of derivative that kneecapped the American International Group - to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro.”
Wrong. AIG-type credit default swaps are not the same as the plain-vanilla credit default swaps that were used for Greece. What “kneecapped” AIG were the credit default swaps it sold on collateralized debt obligations, rickety piles of securities built on all sorts of assets, including bad subprime mortgage loans. Same universe, different planet.
3. The NYT: “NO TRANSPARENCY..A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can't compare offerings. Private markets also lack the rules that prevail in regulated markets - like capital requirements, record-keeping and disclosure...”
Transparency already exists via government-mandated data warehouses for all of the major types of derivatives -- just check out the one for credit derivatives and you'll see how extensive it is.
4. The NYT: “That is why it is so essential to move derivative trades onto fully transparent exchanges."
It's a pipedream to think anyone on the planet can suddenly move a $60 trillion over-the-counter market onto exchanges -- $60 trillion that sure sounds scary, being about the size of the entire world's GDP, although it's a sum that is likely smaller after netting.
Is there a misapprehension here of the differences between over-the-counter markets and exchange-traded instruments?
Not every security can trade on an exchange due to problems with illiquidity and pricing thresholds. One size cannot fit all. You can't neatly fit a $60 trillion boulder, or whatever size rock, in an exchange peg.
Missing here is the fact that for months now the U.S. Treasury, the Federal Reserve, the Depository Trust Clearing Corp. and the CME Group, the world's leading derivatives marketplace, have been working on a centralized clearinghouse for derivatives that addresses market transparency and pricing issues.
A Stanford University study shows a centralized clearinghouse haphazardly launched could mean big losses if it, say, issues wrong data about netting of derivatives (we've seen that before in the NYTs).
5. The NYT: “Both the administration and the House would exclude from exchange trading the estimated $50 trillion market in foreign exchange swaps - similar to the derivatives Greece used to hide its debt. The rationale for the exclusion never has been clearly explained.”
The industry is already looking to invest in FX clearing services, a point not noted. And the rationale for the exclusion is indeed logical.
The FX market is quite a different animal because more than 80% of the trades are overwhelmingly short-dated (less than a week). Also the risk is clearly not counterparty credit risk, but settlement risk. And, the total size of the currency swaps market at issue in Greece is a fraction of the total $50 trillion foreign exchange market (again, netting here would make th is sum smaller).
5. The NYT: “LIMITED POWER TO STOP ABUSES. When the House put out a draft of new rules in October, it sensibly gave regulators the power to ban abusive derivatives…In the final House bill, however, the ban was replaced with a requirement that regulators simply report to Congress if they believe abuses are occurring.”
Not addressed: What government bureaucrats are going to be on the committee that determines which derivatives are "potentially damaging to the system,” who gets to nominate those bureaucrats, and what expertise should they have?
6. The NYT:“Current law also exempts unregulated derivatives from state antigambling laws. That means that states have no power to police their use for excessive speculation.”
AIG successfully lobbied to be regulated by the Office of Thrift Supervision. Look where that got us.
The government is already acting to crack down on derivatives abuses. Time to acknowledge that and stop with the sensationalism.
(And look at this whopper of an error from the BBC, "government bonds come with an insurance policy, called with a credit default swap." No they don't).
Case for Banning Swaps
Wolfgang Münchau in the Financial Timesmade a strong case for outlawing the use of naked credit default swaps, arguing “not even the most libertarian extremist would accept that you could take out insurance on your neighbour's house or the life of your boss.”
In naked swaps, the buyer or the seller do not own the underlying bonds. They are a weathervane bet that a country or a company will default, and face higher borrowing costs.
John Geanakoplos notes that swaps can raise borrowing costs, and can trigger a pile-on effect, where traders (as in equities) jump on the momentum bandwagon to reap profits, even if it means insolvency, which Fed chairman Ben Bernanke says ought to be probed.
Rajiv Sethi, Professor of Economics, Barnard College, Columbia University, also provides smart analysis .
What Anti-Swaps Crowd Misses
What's important is to distinguish between swaps beneficially used to hedge market exposures (which, let's face it, helps protect bank capital needed for loans) and swaps used for pure speculation—impossible to legislate out of existence, but which can be curbed if dangerous.
Market experts also say naked swaps did not cause the Eurozone's problems or the global financial crisis. Instead, reckless leveraging by Europe and Wall Street did, as well as lack of government guardrails.
Columnist Salmon says credit default swaps add liquidity to the market, which can help banks raise capital (needed, say, to make loans) “when the secondary markets are full of uncertainty and turmoil.”
And Sam Jones of FTAlphaville makes the smart point that there is "no opportunistic" attack on Greece's bonds by speculators now underway, that hedge funds made these swap deals way before the crisis blew.
Also, hedge funds are settling these swap trades — essentially akin to ripping up a homeowners' insurance policy — by buying Greece's bonds, ironically putting a floor under those very bonds thought to be under fire.
Ban Swaps, Ban Other Derivatives Too
If you ban credit default swaps and naked swaps, which are bets on bonds, then do you ban other similar derivatives bets on equities, including equity options and naked puts that have been traded successfully for years?
Mary & John Q Public have every right to use their brokerage account to buy or sell naked puts, just as big banks do, after reading about the risks and signing an options agreement. Losing money on a product doesn't mean you should ban them.
Regulate and risk manage them. You don't make matches illegal because they can burn a building down -- they can be a source of light and heat, especially in a dark economic tunnel.
Even Warren Buffett uses these “weapons of mass destruction,” as Berkshire Hathaway's fourth-quarter blowout earnings included derivatives gains totaling $1.5 billion—and Berkshire also sold credit default swaps.
Orange County Revisited
The oft-cited proof that derivatives are nuclear waste is Orange County, Calif.'s bankruptcy in 1994, triggered by bad bets on floating-rate interest rate swaps overseen by county treasurer-tax collector Robert Citron.
But that misses the point that Orange County may have made money on these trades if it had stuck it out after interest rates turned against it and rose, since rates did eventually drop.
And lost, too, is this important fact--Orange County under Citron's stewardship had virtually no cushion to support its highly leveraged bets using the repo markets. A case for more powerful risk management, not against derivatives.