When the government thinks that someone else can do a job better or cheaper, it hires a private contractor.
This explains the upswing of privatization in everything from prisons to embassy security.
[img]569|left|||no_popup[/img]
In the wake of the worst financial meltdown since the Great Depression, Congress and the Obama administration are now taking a hard look at regulating the derivatives market. Before the crash, the global derivatives business was valued at $592 trillion, a figure that dwarfed the combined worth of the stock, bond and commodities markets.
At the President’s behest, Congress is fielding proposals for a regulatory overhaul of the financial industry that would include reining in a derivatives market that has grown nearly seven-fold since 2000. The collapse of the credit markets, in large measure, can be traced to the failure of lawmakers to take on this complex and little understood aspect of the financial world.
A Question of Leverage
Nine years ago, with substantial pressure from the prior administration, Congress exempted financial instruments, such as credit-default swaps, from oversight. After forking out upwards of $182 billion to bail out AIG because of the counter-party claims relating to credit-default swaps, Congress now wants to get a regulatory grip on this market.
Most observers agree, that in the lead-up to the meltdown, companies like AIG were allowed to take on too much leverage secured by too little capital or too little collateral. As a result, when AIG or the now extinct Lehman Brothers were hit with redemption demands from investors holding the credit-default swaps that were guaranteeing the value of their mortgage-backed securities, there wasn’t enough in the kitty to cover their claims.
[img]570|left|||no_popup[/img] Regulators didn’t react sooner to the problem because they simply did not understand, or even perceive, what was happening. Because they previously declined to take an oversight role, there was no one in authority at the state or federal level who knew enough about the market to sound the alarm.
Goldman Sachs knew what was happening. So did the portfolio managers at France’s Societe Generale.
According to recently disclosed regulatory filings, 15 months before the September bailout of AIG, Goldman Sachs and Societe Generale extracted about $11.4 billion from insurers. As the value of their holdings started to fall, these two firms demanded to hold cash as collateral against anticipated losses on mortgage-linked securities.
How to Swamp AIG
Other firms like JP Morgan Chase and Morgan Stanley also made similar collateral demands to AIG. In all, AIG was forced to pay out nearly $18.5 billion to investors whose portfolios of mortgage-backed securities were insured by AIG-issued credit-default swaps.
All of this happened right under the regulators’ noses. None even had a hint that something was wrong before it was too late. By the time regulators figured out what had happened, their only recourse was to let AIG go under or start writing fat checks to keep it from going bust.
Now that the damage is done, the government wants to keep it from happening again.
Their heart is in the right place, but they don’t have the shoes to wade through the murky complexities of this market. In other words, there is no one on the governmental side of the equation who has enough working knowledge of the derivatives industry to supply the needed regulatory oversight.
Although it’s usually a bad idea to let the fox guard the hen house, that’s precisely what federal regulators must do if they want to keep an eye on the derivatives market. Unless and until, agencies like the Commodities Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC) hire enough trained personnel who understand the nature of the beast, federal regulators have little choice other than to let the industry to police itself.
This type of imperfect self-regulatory model is already being employed by the commodities and securities industries. The National Futures Assn. (NFA) and National Assn. of Securities Dealers (NASD) already perform this oversight function for their respective industries.
While this system of oversight is deeply flawed, and subject to industry influence, it’s better than nothing, and may provide a quick-fix that will allow the derivatives market to function smoothly until the regulators are able to bring themselves up to speed.
That should provide adequate time for the evil geniuses who roam Wall Street to cook up an even more convoluted array of financial instruments to confound regulators and fleece investors.
John Cohn is a senior partner in the Globe West Financial Group, based in West Los Angeles. He may be contacted at www.globewestfinancial.com
