New house rules: how the Feds are seeking to make the world safe for derivatives

International Economy, The, Summer, 2004 by Christopher Whalen

The Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Reserve, Federal Deposit Insurance Corporation, and Securities and Exchange Commission are worried. On May 13, the five regulators issued a joint statement, "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities," seeking public comment on a new round of internal controls and risk management procedures to rein in financial institutions that engage in "complex structured finance activities," also known as derivatives. After having encouraged the use of imaginary securities in the 1990s as a way to offset risk in volatile markets, regulators led by the Federal Reserve Board now evidence a certain degree of hysteria. Why? Because the very derivatives that have long been promoted by regulators and Wall Street as useful tools to manage risk are showing signs of getting out of control.

A couple of months ago, Federal Reserve Board Chairman Alan Greenspan fretted about the "systemic" threat posed to the financial markets by government-sponsored enterprises such as Fannie Mae, but in fact it is the big derivatives houses--and their inept customers--that are giving regulators the shakes. The proposal states: "In light of recent events, the OCC, Federal Reserve, and SEC conducted special reviews of several banking and securities firms that are significant participants in the market for complex structured finance products. These reviews were designed to evaluate the product approval, transaction approval, and other internal controls and processes used by these institutions to identify and manage the legal, reputational, and other risks associated with complex structured finance transactions."

The proposed text seems focused on the idea that the banks have gone too far with existing derivatives activities. Most of the language is about reining in the troops and making managers and directors accountable, a la Sarbanes-Oxley, for what products they sell and who they sell them to and based on what disclosure. Yet the proposed statement on "sound practices" suggests that the SEC and other regulators consider derivatives-dealing activities appropriate and, indeed, co-equal with the other activities of a well-managed financial institution. Have American prudential standards fallen so far that we wish to publicly embrace the view that derivatives trading is actually a productive way to deploy capital? At the Greenspan dominated Fed, the answer to that question seems to be a resounding "yes."

Derivatives shift wealth opportunistically. The theory behind them is to stabilize risk in volatile markets by providing a means of rectifying a portion of the losses incurred in less liquid activities. However, unlike selling real goods and services, every derivatives transaction is a wager that produces a winner and a loser. In other words, every trade results in a realized loss to one party. Thus derivatives enable smarter firms with deeper talent pools and better information to exploit lesser players. Herein lies the flaw for the financial industry. While volatility is stabilized for a few, the net effect on the system is negative as the mounting losses are merely passed to the dumbest player at the table.

The reality is that most banks and non-bank financial institutions do not have the scale, internal systems, and--most important--human resources needed to compete successfully in the derivatives market. Consider one example: the July 2001 failure of Superior Bank, FSB, a small community bank in Illinois that was rendered insolvent in a matter of months by losses from toxic derivatives, in this case residual interests in a portfolio of sub-prime loans. John M. Reich, Vice Chairman of the FDIC, told Congress in September 2001: "Since 1998, failures of institutions with risk characteristics similar to those of Superior have cost the FDIC insurance funds more than $1 billion."

Along with the new Basel II bank capital guidelines, the proposed procedures for complex structured transactions are, in a very simplistic sense, an attempt to make the world safe for derivatives. Unfortunately, every game of chance must have a chump, and the broadening of the pool of players, from private investors to mutual funds to banks, means that larger and larger swaths of American society are now put at risk to feed Wall Street's need for new suckers. Or to put it another way, if giant organizations the size of Washington Mutual or Fannie Mae cannot manage the duration risk of relatively pedestrian mortgage portfolios, what makes the regulators think that the vast majority of smaller institutions can do any better playing in the world of customized derivatives contracts, the type of dealings made infamous by Enron and Bankers Trust?

The real risk posed to the U.S. consumer by derivatives is not that one of the larger players will suffer a catastrophic loss and collapse into the arms of Uncle Sam, in what is known as the "too big to fail" scenario. Rather, the hazard is that a steady procession of smaller banks and funds will be consumed by losses on derivatives, generating chaos and mayhem in their communities but going largely unnoticed by the servile politicians and big media that patronize the largest financial houses.