The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Patricia White, Associate Director, Division of Research and Statistics

Over-the-counter derivatives

Before the Subcommittee on Securities, Insurance, and Investment, Committee of Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.

June 22, 2009

Chairman Reed, Ranking Member Bunning, and other members of the Subcommittee, I appreciate this opportunity to provide the Federal Reserve Board’s views on the development of a new regulatory structure for the over-the-counter (OTC) derivatives market. The Board brings to this policy debate both its interest in ensuring financial stability and its role as a supervisor of banking institutions. Today, I will describe the broad objectives that the Board believes should guide policymakers as they devise the new structure and identify key elements that will support those objectives. Supervision of derivative dealers is a fundamental element of the oversight of OTC derivative markets, and I also will discuss the steps necessary to ensure these firms employ adequate risk management.

Policy Objectives

Mitigation of Systemic Risk
The events of the last two years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks.

Centralized clearing of standardized OTC products is a key component of efforts to mitigate such systemic risk. One method of achieving centralized clearing is to establish central counterparties, or CCPs, for OTC products. Market participants have already established several CCPs to provide clearing services for some OTC interest rate, energy, and credit derivative contracts. Regulators both in the United States and abroad are seeking to speed the development of new CCPs and to broaden the product line of existing CCPs.

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Our earlier post on Exhausted Unemployment claims has provoked an interesting (if wonky) discussion on Claims Exhaustion.

Yes, it is a moving average, but that rise starting in December 2007 — when the recession began — which spiked vertically is unmistakable.

Here is the Labor Department data source, and their description of the data series:

“The monthly summary report is intended to provide the user with a quick overview of the status of the UI system at the national and state levels. This summary report contains monthly information on claims activities and on the number and amount of payments under State unemployment insurance laws. This data is used in budgetary and administrative planning, program evaluation, and reports to Congress and the public.”

The data goes back to 1972.

I looked at a simple 24 month series:

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As was noted by Transor Z earlier:

Since Exhaustion Rate was first reported for the 6/72 data set, the average value has been 34% and the median value has been 33%.

In 37 years there have been 44 monthly values of 40% or higher. Only 7 of these were NOT in the period 2002-2009 and the highest of these was the 8/31/83 set with 40.83.

38.3 was the peak for the 1970s — 11/30/76.
40.83 was the high for the 1980s — 8/31/83.
40.11 was the high for the 1990s — 11/30/92

Until 3/31/09, the previous all-time high was set in 7/31/03 with 43.9. The March, April, and May figures have set successive all-time highs. You have to go back to 1/31/91 (29.87) to find a rate under 30%.

When you plot 12-month average benefits duration on the same graph, you see a clear correlation between the two. One question the data raise is that, during the early 80s recession, the average went over 17 weeks from 5/31/82 to 3/31/83. The 27 year average is 14.76 weeks. The latest figures put us only at 15.67 weeks. Given that even the “green shoots” crowd is predicting a jobless recovery at least in the short term, a 17+ week average would seem likely to follow, sending the exhaustion rate to further 27-year highs.

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Here is another good chart showing the 2009 highs significantly above prior peaks:

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Unemployment Benefit Exhaustions
Regular State UI Final Payments, Data from 1972 to 2009

Chart via BLS)

Exhaustions are the number of claimants who collect their full entitlement of unemployment insurance benefits. The data shown in the chart are for the regular state program.

(Hat tip, Kid Dynamite)

Barry Ritholtz, author of the new bestseller “Bailout Nation”, blames Alan Greenspan for America’s financial collapse and says troubled banks should be allowed to fail.

click for video

While still finishing up almost .03 for the week ended Sunday, AAA said the average price of a gallon of unleaded gasoline fell Sunday for the first time since April 28th, a 53 day streak without a drop. At $2.69, it is up .76 since March 18th, the day the FOMC announced they were going to start buying US Treasuries and raised the size of its MBS and Agency purchases. Even with today’s selloff, the 19 commodity CRB index is up about 14% (vs a 15% gain in the S&P 500, thus the REAL RETURN in terms of commodities is virtually nil) from March 17th and the implied inflation rate in the 10 yr TIPS has risen to 1.84% from 1.22%. The 10 yr bond yield is up 70 bps from March 17th and the average 30 yr mortgage rate at 5.47% (from Bankrate.com) is up 30 bps in that time frame and 62 bps off its April low. We know the FOMC will talk about the economy getting less worse BUT will they repeat that they expect “inflation will remain subdued” ?

After the note I just sent on the Fed, the MBA said that after raising its forecast for mortgage originations by over $800b in March after the Fed’s QE plan and the subsequent decline in interest rates, they are cutting its ’09 est by $700b. 88% of the cut is due to refi’s as the Fed “has not been successful in maintaining lower treasury yields.” In March when they raised their estimate they had this caveat, “with the billions in Treasury securities that would be issued to finance record budget deficits and with the Fed expected to purchase only a portion of those, how long rates stayed low would depend on whether other investors stayed in the market. If other investors shied away from Treasuries due to expectations of future inflation and the declining value of the $, the effect on rates would be more short-lived and our mortgage originations forecast would prove too optimistic.” “That has proven to be the case.”

I  just love this info/chart porn:

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Proposed Changes in Federal Regulation of the Financial Industry
click for ginormous graphic

via NYT

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Source:
Some Lawmakers Question Expanded Reach for the Fed
STEPHEN LABATON
NYT, June 17, 2009

http://www.nytimes.com/2009/06/18/business/18regulate.html

Home-sellers continue to have a hard time making a sale.

Last week, we saw Continuing Claims decrease — proof, said the green shooters, of the imminent economic recovery.

Only, not so much:

Those of you (who can still afford the luxury of) a trusty Bloomberg will note the ‘exhaustion rate’ for jobless benefits – EXHTRATE – reveals that people are not leaving the pool of continuing unemployment claims because they are getting new jobs; Rather, they are leaving because they have exhausted their benefits.

They are now unemployed AND broke. That is hardly a green shoot . . .
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Exhaustion Rate: U.S. Workers Losing Unemployment Aid

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Hat tip Bill King

Here are my prepared remarks for the Senate Banking Committee later today.  The hearing starts at 15:00 in Room 538 DSOB (Dirkson Senate Office Building).   Drinks and poetry readings at Kelly’s Irish Times afterward.  — Chris

Over-the-Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks

Statement by Christopher Whalen

Committee on Banking, Housing and Urban Affairs

Subcommittee on Securities, Insurance, and Investment

United States Senate

June 22, 2009

Chairman Reed,  Senator Bunning, Members of the Committee:

Thank you for requesting my testimony today regarding the operation and regulation of over-the-counter or “OTC” derivatives markets.  My name is Christopher Whalen and I live in the State of New York.[1] I work in the financial community as an analyst and a principal of a firm that rates the performance of commercial banks.  I previously appeared before the full Committee in March of this year to discuss regulatory reform.

First let me make a couple of points for the Committee on how to think about OTC derivatives.  Then I will answer your questions in summary form.  Finally, I provide some additional sources and references to help you in your deliberations.

1)          Defining OTC Asset Classes:

When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or “CDS” contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another.  You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or “CDOs,” for these too are OTC “derivatives” that purport to derive their “value” from another asset or instrument.

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A few technical glitches this AM as the site’s sql db went all squelchy on me.

Seems to be up now; more posts to follow…