Here is an excerpt from our latest issue of The Institutional Risk Analyst comment and some additional thoughts since we’ve published.  Got some very good responses/retorts that we’ll share with with la famiglia ritholtz as with previous comments.

“Kabuki is classical ancient Japanese folk theater performed broadly and loudly for the general public. I became familiar with it when I lived in Tokyo years ago. Kabuki on the Potomac this week fit Kabuki’s theatrical definition with lawmakers wailing loudly, uttering angry threats, and rhythmically pounding podiums in a performance of mangled metaphors and fantasy.”

The Rag Blog
March 22, 2009

We gratefully acknowledge contributions for today’s comment from members of the Herbert Gold Society, an informal group of current and former employees of the U.S. Treasury and the Federal Reserve System.

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (“CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (“OTC”) derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits – and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the “profits” earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

As we told Tim Rayment of The Times of London in his article, “Joseph Cassano: the man with the trillion-dollar price on his head,” in our view AIG never had the possibility of generating sufficient income to cover its CDS contracts, thus honoring these gaming debts of AIG at face value as Tim Geithner, Ben Bernanke, et al., have done using public funds is ridiculous, even criminal. As we’ve said before, AIG should be in bankruptcy so that all creditors may be treated fairly – but “fairly” means a steep discount to par value without the subsidy from the Fed.

Click here to read the rest of this issue of The Institutional Risk Analyst

We got a number of very good comments on this post, including one from Ron Kirby of Kirby Analytics, who argues that interest rate contracts, not CDS, are were the big lie truly resides.  Ron was a little excited, but he makes good points.  To me, though, CDS is an order of magnitude different problem because there is no visible “basis” for the pricing, thus most of the contracts never reflect true P(d) risk.  This C is still < 1,000bp over the curve.  Chris

Christopher;

Your article mistakenly cites CDSs as the epi-center of the derivatives mess.  The rest of the derivatives are only referred to as “other OTC derivatives”.

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (“CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (“OTC”) derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits – and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM.

Your article asks about or suggests that there was a desperate “battle” in the OTC derivatives market, but then speaks in terms of it being about J.P. Morgan wanting or needing to earn excessive rents to survive?

This completely misses the mark.  You have not identified “the major” contributor of this excess AT ALL.

Look at the concentration of derivatives as reported by the OCC:

66+ of 91 Trillion notional at J.P. M. is interest rate exposure.  22+ of 34 Trillion at Citi the same.  16+ Trillion of 32 at BofA.  And all your article mentions is CDS???

Much of these interest rate derivatives are interest rate swaps [IRS].  IRS > 3yrs. duration typically have U.S. government bond trades embedded in them.  Total outstanding U.S. debt is 11 or so Trillion.  So, ask yourself why all this trading when there is DEMONSTRABLY NO end user demand for this crap:

If you follow John Williams’ work – www.shadowstats.com you know that official inflation reporting is “jacked beyond belief”.  The interest rate FRAUD goes hand-in-hand.

The creation of this interest rate DEBACLE is tantamount to the GROSS mis-pricing of capital which all other economic excess [including the tech boom, real-estate boom and CDS extravaganza] stemmed from.

Additionally, given the size of J.P. Morgan’s derivatives book and the fact that the contents thereof have crippled or killed other institutions with fractions of their exposure, other BIGGER questions should be asked.  When you read the following – given what is already known – it should make one wonder if accounting even happens at J.P. Morgan:

First reported by Dawn Kopecki back in 2006 when she reported in BusinessWeek Online in a piece titled, Intelligence Czar Can Waive SEC Rules,

“President George W. Bush has bestowed on his [then] intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.”

What this means folks, if institutions like J.P. Morgan are deemed to be integral to U.S. National Security – they could be “legally” excused from reporting their true financial condition.

The entry in the Federal Register is described as follows:

The memo Bush signed on May 5, which was published seven days later in the Federal Register, had the unrevealing title “Assignment of Function Relating to Granting of Authority for Issuance of Certain Directives: Memorandum for the Director of National Intelligence.” In the document, Bush addressed Negroponte, saying: “I hereby assign to you the function of the President under section 13(b)(3)(A) of the Securities Exchange Act of 1934, as amended.”

A trip to the statute books showed that the amended version of the 1934 act states that “with respect to matters concerning the national security of the United States,” the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations. These obligations include keeping accurate “books, records, and accounts” and maintaining “a system of internal accounting controls sufficient” to ensure the propriety of financial transactions and the preparation of financial statements in compliance with “generally accepted accounting principles.”

J.P. Morgan “IS” the Federal Reserve in drag.

The CDS Fraud that your article identifies is a “side show” which deflects attention away from the more heinous crime committed with “neutering usury” thereby allowing the U.S. Treasury and Private Federal Reserve to “scapegoat” mostly non-bank entities like AIG, Bear, Lehman and YOUR grandmother as soon as they figure out a way to blame her too!

Best,

Rob Kirby

Category: BP Cafe, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

10 Responses to “Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives + Kirby Comments”

  1. clawback says:

    What is Kirby’s point about the IRS and the yield on Treasurys? It may be obvious to others, but I’m out of my depth on this one. Is he suggesting that Treasury rates are being kept down to keep the banks IRS from blowing up?

    Thanks in advance for any help.

  2. Chris,

    you do a valuable Service by providing your Insight, to the general Weal, FOC.

    As you know, many pay, quantities of Paperbacks, for similiar intel.
    ~~

    clawback,

    ya think? you, just, might be on the right track..might want to, you know, do some Research..

  3. Moss says:

    Didn’t the banks screw many municipalities with IRS linked to their muni bond offerings?

    I sure hope all these economically useless but fee generating voodoo schemes get outlawed.

  4. d4winds says:

    Interest rate swaps can be easily, completely hedged by elementary means; the fixed rate payor’s payment is just a leveling of the forward rate curve. CDS’s are a very different animal and cannot be hedged other than partially and only with instruments whose pricing is every bit as problematic (total return swaps, e.g.). Their pricing necessarily involves formal models using so-called incomplete markets, i.e., non-hedgeable primitives are embedded in the product. (See the text by Schonbucher, e.g). Gaussian (or other) copulas are used to compound the uncertainties surrounding a named-risk by pretending to know, contingent on said uncertainties having been assumed away via faith in the untestable single risk models, how prices co-vary (or, to be more precise, how price-driving modelling parameters, such as the risk-neutral distribution of the time to default, co-vary).

    So, qua “derivative”, CDS’s are a bogus product, since hedges cannot be deduced from the valuation itself to supply a sanity check on the valuation–this being the very meaning of incomplete markets. Since their valuation rests, further, on an assumed pricing (“risk-neutral”) distrubution only tenuously connected (“equivalent measures” is the probabilist’s term for the connection) to the econometric one of history, historical data cannot, by definition, be used to judge their reasonableness either.

    So neither other market data nor past history can be used to guage the reasonability of CDS pricing–and this is so on the very logical, quant-fin grounds used to justify the pricing in the first place.
    By contrast to interest rate swaps, which are highly derivative and hedgeable, they are thus complete “trust me” products.

    Of course, naked CDS’s are also in may ways equivalent to the old, subsequently-outlawed bucket shops which helped exacerbate the Panic of 1907 and would now be illegal were it not for an express exemption from the anit-bucket shop laws by the Commodity Futures Modernization Act. The non-naked CDS’s pose moral hazard issues in preventing negotiated resolutions of reorganizations rather than forced Chapter 11 with a Chapter 7 imminent. They have no rationale as a derivative and no socially defensible purpose other than as fee-makers for Wall Street and as high stakes gambling conduits (with taxpayer backstops for the politically well-heeled).

  5. clawback says:

    @d4winds

    Good points all round. That was one of the questions I had about Kirby’s letter — if we’re talking about IRS, one would think (maybe) that the swaps would be part of a hedge, esp if they were in a trade involving any kind of Treasury. Is Kirby’s concern that they aren’t hedged? Or would that likely be the case given the seeming inability of certain players to use derivatives AS hedges, rather than to increase leverage and blow themselves up.

  6. look at the notional value of the i-rate swaps v. total outstanding $ value of the USTreas complex..

    one # is bigger than the other, even after assuming ‘double-counting’ of ‘both sides’ of the trade..

  7. Chris Whalen says:

    Precisely. I think that is one of Ron’s key points, that the tail is wagging the dog. The fact that this affects interest rates/currencies etc makes the IR story bigger for the global markets than CDS, another point made by Kirby. I think his basic issue was the lack of focus on IR swaps and official shenanigans around same.

  8. emmanuel117 says:

    @Moss:

    Yes. I also believe Larry Summers had Harvard buy some IRS while he was President there. They lost money when Bernanke lowered rates to zero and were forced to pay the banks to get rid of the swaps.

    A note of irony for that future historian.

  9. drollere says:

    don’t get lost in the details here guys. the fundamental point of this post is that two bright guys can’t agree on the basic terms of a discussion, which means they both agree on — the lack of transparency.

    credit or interest swaps are two flavors of the same confection, and the fact that one or the other is more or less necessary, or a greater or lesser portion of the total risk/liability/smoking crater is really beside the point. call it financial engineering, call it insurance, call it gambling — it doesn’t work because nobody can see it work.

    there’s also the poignant fact (for me at least) that kabuki (a stylized performance in which players wear masks and, as part of the genre, must deliver speeches from stereotyped positions within a ritually defined stage) is not the problem here. go ahead, legislate otc’s — then derivatives will become custom contracts again … “customized” by computers. (orwell’s 1984 novel writing machines with a capitalist twist.)

    the fundamental problem here is the culture of credit and debt. the culture of credit and debt created egregiously excessive and historically abrupt (60 years) global wealth. return increases with risk, so risk will always rise in the search for return. thus speculative bubbles are inherent in free markets, unless they are regulated into distribution systems. attempting to mix (or tolerating the coexistence) of free markets and regulated distribution systems only creates black markets, another term for bubbles … or for “custom” derivative products outside the otc exchange accounting.

  10. dunnage says:

    Stress Tests for Money Centers came about so folks wouldn’t ask about the books. Nothing will change down the road: Chase will be the Derivative House and Shadow Banks are just too unbelievably beyond the beyond to give up. Oh, and don’t forget these dudes can still trade commodities — banks they may be, but they of course were given exclusions to the law — extensions abailable and probably already applied for.

    Now you and me and the Commercial Banks are cannon fodder. Corner Office Players at the Money Centers will roll in the dough, but their institutions are going to be on the stretchers for years ala Japan.