September will mark 10 years since the financial-sector meltdown that sparked the worst recession since the 1930s and cost 8.7 million people their jobs. Central to that cataclysm were “over-the-counter derivatives,” which Warren Buffet had famously called “financial weapons of mass destruction.” The 2010 Dodd-Frank act, Congress’s response to the crash, was supposed to shine some light into this vast, black box of a market and put a stake through the heart of Too Big to Fail.
But TBTF may be alive and well. It’s hard to say, exactly, because, as reported in The New York Times recently, much of the OTC derivatives market remains outside the radar of regulators who are supposed to monitor the risks it poses. Opacity proved disastrous in 2008, and it could again.
OTC derivatives are financial instruments that derive their value from an asset like a stock or a home loan. (“Over-the-counter” means they are privately negotiated instruments, as opposed to those that trade on an open exchange). The type of derivative most critical here is known as a “swap” – as in credit default swap, which turned out to be a particularly destructive weapon during the housing meltdown. A CDS is essentially bond insurance that pays off if a borrower defaults, and there were a lot of defaults in 2008. From relatively simple instruments like these springs a global tangle of financial risk that affects not just markets but the real economy.
The less transparent this market, the more dangerous for everyone. Imagine a dozen ninjas in a room, each pitted against the other. As long as all can see who wields what, they have a reasonable idea of their prospects. But turn out the lights and all bets are off. No one has any idea where his opponents stand or how vulnerable he is in relation to them. Everyone becomes a lot more skittish than they would be otherwise. Financial markets are something like that, which is why transparency is so crucial to maintaining confidence in them.
Like our ninjas, financial institutions operating in regulatory shadows are a lot more likely to bail at the first sign of trouble than they would be operating in daylight. Imagine that bank A defaults, or threatens to. In an opaque market no one can be sure whom A owes and how much. What if A’s lender is one of B’s borrowers? And what would that mean for B’s lenders? Opacity breeds uncertainty, which can make market crashes self-fulfilling. First comes a financial shock of some sort, then serial defaults as loans get called and assets are sold in order to pay up. Panic selling sends prices plummeting, forcing more selling, and so forth – a vicious cycle that, if severe enough, can send the whole global economy into recession.
When that happens, TBTF will be on the doorstep once again, forcing governments to decide whether to let the world collapse or bill taxpayers for another titanic bailout. This is more or less what happened in 2008, among large institutions like Lehmann and AIG and their various counterparties. The opacity of the pre-crash derivatives market was no accident: Congress deliberately refused to address this danger in 2000, when it passed (and Bill Clinton signed) the Commodity Futures Modernization Act, which left the riskiest OTC derivatives largely unregulated.
That was a monumental error that should have been foreseen. In 1998, at the very moment regulators were debating whether to tighten regulation of OTC derivatives, the collapse of a high-risk fund managed by Long Term Capital Management, which had gambled heavily with derivatives and lost, rattled world markets. Unregulated derivatives would play a significant role in the 2002 Enron collapse and, of course, the 2008 crash. A key cause of both, in other words, was not just deregulating but refusing to regulate in the first place.
Dodd-Frank tries to contain risk in several ways, like requiring that derivatives transactions be “centrally cleared,” helping to reduce panic in the event of a market shock. It also created the Financial Stability Oversight Council, tasked with monitoring the financial system for signs of excessive risk. But Republican lawmakers are trying to gut the FSOC of its key powers, including the authority to designate certain financial institutions as “systemically important” – aka TBTF – which would put them on shorter regulatory leashes.
Elsewhere, regulators have proposed closing a Dodd-Frank loophole, described in the Times story, that leaves the derivatives holdings of offshore U.S. bank affiliates outside the regulatory radar. The Trump administration has apparently dropped that effort.
“The size and severity of this blind spot are hard to measure,” writes the Times. “One consequence is that United States regulators are unable to grasp the full exposure of American banks to their foreign rivals.”
Exactly. What you’re seeing here is a dilemma that market purists never quite resolve: They say they want market transparency, and they oppose government regulation. But what if transparency requires regulation?
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