Posts filed under “Derivatives”

Our story thus far:  The Commodity Futures Modernization Act of 2000, sponsored by Texas Senator Phil Gramm as a favor to his wife Wendy (who sat on the Board of Directors of Enron, which wanted to trade energy derivatives without oversight) was rushed through Congress in 2000. Unread by Congress or their staffers, it was signed into law by President Bill Clinton on the advice of his Treasury Secretary Lawrence Summers.

The CFMA radically deregulated derivatives. The law changed the Commodity Exchange Act of 1936 (CEA) to exempt derivatives transactions from regulations as either “futures” (under the CEA) or “securities” under federal securities laws. Further, the CFMA specifically exempted Credit Defaults Swaps and other derivative products from regulation by any State Insurance Board or Regulators.

This rule change exempting CDS from insurance oversight led to a very specific economic behavioral change: Companies that wrote insurance had to explicitly reserve for expected losses and eventual payout in a conservative manner. Companies that wrote Credit Defaults Swaps did not.

Hence, AIG was able to underwrite over THREE TRILLION DOLLARS worth of derivatives, reserving precisely zero dollars agianst potential claims. This was enormously lucrative, except for that whole crashing & burning into insolvency thingie.

The radical deregulation the CFMA generated led directly to the collapse of AIG, Bear Stearns and Lehman Brothers; indirectly to the collapse of Citigroup, Bank of America, and Fannie/Freddie. It was a significant factor in the near death experiences of Goldman, Morgan Stanley and others.

Despite the horrific impact this legislation had, it was never actually overturned, only modified. Obama made the personnel error of bringing back Larry Summers (he apparently had not wrought enough damage to the nation yet). Rather than admit the error of CFMA, and overturn it, Summers instead downplayed its role. Thus, the CFMA was merely modified somewhat. The same risk the CFMA presented to the economy still exists. Swaps now must be be cleared through exchanges or clearinghouses — but they are still exempt from Insurance regulations. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement. Counter-parties may or may not demand one, but the dollar amount is negotiable.

Which brings us to today.

The Greek government has been declared in default by S&P; most common sense definitions of default — failing to make payments on a timely basis, declaring your intention to default, involuntary change of loan terms by borrower, etc. — have already occurred.

That last point is especially important in light of the Greek Sovereign Debt default — which International Swaps and Derivatives Association, in a nonpublic meeting of derivatives bankers, declared to be a NONDEFAULT.

I’ll be damned if I can figure out why.

Any tradeable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year.  No interpretation required.

Yet with Greek CDS, we have a committee of bankers, lawyers, accountants and other interested (not unbiased) parties interpreting the details, weighing the circumstances, describing what happened.

Does that sound like a tradeable asset to you?  To me, it sounds more like an insurance policy dispute. Because in reality, these CDS are in fact, nothing more than an unreserved and unregulated insurance productts.  That is the legacy of the CFMA, and one that apparently has not been overturned.

The banks, hedge funds, and securities firms who are the prime dealers of these products  greatly prefer to have their derivatives supervised by Federal regulators. Why? Because the standards they use — general safety and soundness — are empty-headed nonsense, easily evaded.

The State Insurance Boards and Regulators are far more exacting, far more specific — and require boatloads more money in reserve.

Hence, this is how the Greeks have managed to default, yet an insurance-like product will not (yet) payout. With insurers or their regulators involved, this would never have happened.

Category: Derivatives, Really, really bad calls, Regulation

ISDA: Suckers Wanted

“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps.” > Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called…Read More

Category: Derivatives, Really, really bad calls

Fat Cats and Starving Dogs; Happy Foxes and Sad Sacks

This weekend, I saw Margin Call on DVD. Jeremy Irons plays a CEO of a small Goldman Sachs like company. A young analyst at the firm discovers that their highly-leveraged, massive mortgage bets are based on a VAR formula that’s flawed. It failed to consider volatility ranges beyond historical distributions. With the market swinging, his…Read More

Category: Bailouts, Derivatives, Film

Re-hypothecation: How it’s related to MF Global

Marketplace Whiteboard:

If ever there was a word that you’d expect to find in a Harry Potter  novel, it’s re-hypothecation. This a classic example of financial  people inventing impenetrable terminology to make their business look  like a black art. “Oooh, re-hypothecation, it must be magic!”

Well it isn’t.

The term “re-hypothecation” came up a lot during the MF Global meltdown; It’s quite a common term in the securities market – but what does it mean?

To explain re-hypothecation, we have to explain hypothecation. And  hypothecation is pretty simple. It’s when you lend someone money and let  the borrower keep the collateral.


Re-hypothecation: How it’s related to MF Global
Paddy Hirsch
Marketplace Jan 4, 2012

Category: Derivatives, Legal, Video

MBIA vs BAC: On why the loss causation ruling is important

“Bank of America Corp. may face billions of dollars more in liability for faulty mortgages if a judge agrees with insurer MBIA Inc. that the lender must buy back loans even if the errors didn’t cause a borrower’s default…If New York Supreme Court Justice Eileen Bransten and judges in similar cases across the country rule…Read More

Category: Derivatives, Legal, Think Tank

The (sizable) Role of Rehypothecation in the Shadow Banking System

The (sizable) Role of Rehypothecation in the Shadow Banking System Singh, Manmohan ; Aitken, James July 01, 2010 ~~~ This paper examines the sizable role of rehypothecation in the shadow banking system. Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to its prime broker to be used again as collateral…Read More

Category: Credit, Derivatives, Regulation, Think Tank

MF Global Collapse Reveals Systemic Risk

> My Sunday Washington Post column is out this morning. Today, we look at The systemic risk revealed by MF Global’s collapse. As has been the case so many times, the details of this debacle are found in the regulatory changes lobbied for — and recieved — by Corzine and the MF Global legal crew….Read More

Category: Apprenticed Investor, Credit, Derivatives, Legal

The (sizable) Role of Rehypothecation In The Shadow Banking System

IMF Working Paper Monetary and Capital Markets Department The (sizable) Role of Rehypothecation in the Shadow Banking System Prepared by Manmohan Singh and James Aitken1 Authorized for distribution by Karl Habermeier July 2010 ~~~

Category: Credit, Derivatives, Think Tank

Ratigan: Inside the Unregulated Shadow Swaps Market

Visit for breaking news, world news, and news about the economy

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Category: Derivatives, Media, Regulation, Video

Discuss: Goldman Is the New Master of the EU?

Discuss: The Independent writes: “This is The Goldman Sachs Project. Put simply, it is to hug governments close. Every business wants to advance its interests with the regulators that can stymie them and the politicians who can give them a tax break, but this is no mere lobbying effort. Goldman is there to provide advice…Read More

Category: Bailouts, Credit, Derivatives