Derivatives – The Dark Market

[Dakinikat here:  We at Sky Dancing would like welcome fiscalliberal to the Front page!!!]

The major objective of this article is to begin the process of understanding the financial market to enable intelligent discussion on the blog.

One of the major pillars of financial collapse was Derivatives. They are very complex financial instruments with a wide diversity. They are described by a gaggle of terminology used by the high priests of finance. Because of complexity most of the books on the collapse skirt the detail of the Derivative Market. After we get through some basic definitions, we will focus on Credit Default Swaps (CDS); a subset of the Derivatives offerings. We will see how the government created a non regulated environment where fraud, compromised regulators and incompetent people ran the Investment Financial community in a very high risk mode.

Derivatives Defined

A Derivative is a financial instrument whose value is dependent on the value of another entity at a future time. Its primary function is to mitigate risk. A simple analogy would be your Home insurance. These policies guarantee that you will be remunerated if the value of your home falls due to fire, wind, or accident.  A relatively small premium of money can mitigate a large potential financial catastrophe. State regulators are in charge of most regular Insurance products and solvency is less of an issue as adequate capital reserves are defined.

We need to think of Derivatives as a “risk tool” meant to stabilize the financial businesses (markets). The wide variety of Derivatives creates confusion, so we are going to restrict our discussion to Credit Default Swaps (CDS).   Anticipating problems with Sub Prime mortgages, Securities were insured by investors. It was the Credit Default Swaps inability to perform that was a party to the financial collapse after the Lehman bankruptcy. They did not have the financial reserves to back up the policies they wrote How did that happen?

Deregulation

For our discussion today, three government deregulation actions are relevant.

  • 1999 Graham Leach Bliley Act repealed the 1933 Glass Steagall act. The Glass-Steagall Act prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company.
  • April 28, 2004 SEC drastically relaxed leverage standards for the Big Five Investment Banks: Goldman, Merrill, Bear, Lehman and Morgan Stanly. This created a very high risk environment.  The session can be viewed here.

Financial self regulation brought the system down in 8 years. Bush de-funded Federal regulation. Greed, incompetence and corruption reigned supreme. Enron people went to jail. As of 2010, under Obama only bit players have been jailed. Civil fines are a joke.

Securitization Market

We need to understand the environment created by the above regulation changes  to understand the role of CDS Derivative failure. We will concentrate on the Real Estate Industry

Traditionally, according to HBSwiss, the real estate industry was handled by local banks who retained the loans. Their exposure to losses resulted in more careful origination of loans. For a long time, Fannie, Freddie and FHA were packaging (securitizing) mortgages and selling them to Investors. They enjoyed a good reputation because they had good loan origination standards. These were categorized as Prime mortgages. Generally these securities obtained a AAA rating which rarely changed. Good consistent returns were recorded with these products.

Early in the 2000 decade the Investment banks adopted the securitization model called Private Label Securities. They purchased their mortgages from unregulated brokers (Country Wide, Ameriquest etc) who had little or no standards regarding underwriting of loans. The private label market latched on to the fact that high risk “Sub Prime”  loans carried higher interest rates, hence higher profits. They had no exposure to the failure of the loan as risk was passed on to the Investors. They simply collected the lucrative fee’s.

Investment Banks packaged the loans (millions and billion level). They paid the rating agencies (S&P. Moody and Fitch) for ratings structuring the packages to get AAA ratings. It is clear the rating agencies did not do their job as traditionally solid AAA ratings were changed as the packages started to fail. These packages were sold to the domestic and world markets. Trillions of dollars were involved. The banks simply passed the risk on to the investors and collected the origination and servicing fee’s

CDS Market

Risk could be mitigated by purchasing a CDS against the failure of the security. So if the security failed the investor was held harmless. Remember that as of 2000 the CDS  market was unregulated. AIG – London Financial Services is the poster child of the CDS industry. AIG wrote most of the CDS contracts cheaply as they held inadequate reserves (in the event of a default) and had a good company rating based on the parent insurance company whose operations were regulated. Office of Thrift Supervision was the responsible regulator, but their presence was effectively non existent, Goldman Sachs (Hank Paulson as CEO) was one of their major clients.

However, late 2006 / 2007 AIG FP realized they were over exposed and got out of the market retaining the previous contracts. Recall in the unregulated market anyone could write CDS and the big banks did. As the Mortgage Backed Securities began to fail, the banks started writing CDS between the banks to mitigate risk always falsely believing the market would recover. This was necessary because When Bear and Lehman started to fail the banks were joined at the hip, guaranteeing each others toxic securities. Based on the 2004 SEC relaxing reserve requirements, that banks were leveraged up and things were starting to fail. In a leveraged market things get serious to critical in a matter of hours.

The daily, weekly and monthly credit markets froze up because nobody trusted anybody. Even GE was having trouble borrowing for daily operations. Andrew Ross Sorkin’s book‘Too Big to Fail’— gives a good account of the scenario in 2008. Fannie and Freddie were in conservator ship, near bankruptcy Bear was bought on a fire sale by JP Morgan, Lehman was bankrupt, Merrill near bankruptcy was bought by Bank Of America and AIG had to be rescued by the Federal Government. Morgan Stanly and Goldman were within days of bankruptcy, but got bailed out by Warren Buffet and a Korean financial entity.

The AIG story is discussed in this newspaper article ‘Behind Insurer’s Crisis, Blind Eye to a Web of Risk’.

It is interesting to know that just before the 2008 collapse, the rating agencies down graded AIG forcing them to hold more reserves. They were forced to raise cash in a collapsing market.  In a high leverage industry, when it rains it pours.

Naked CDS

Investors can buy CDS on securities even though they do not own the security. This is equivalent to a neighbor buying insurance on your house. So if you know that a Mortgage Backed Security has a lot of high risk loans in it and is headed to failure, you buy a CDS anticipating the default. Michael Lewis’ book‘The Big Short’–is all about the people who anticipated the failures and bought CDS products. A Bloomberg video interviews Lewis and it provides a lot of insight into the mess that evolved.

I look to Dakinkat, Gillian Tett, Yves Smith, and Janet Tavakoli on technical issues of Derivatives. Lewis’ forte is being able to write to the general public. His book gives a lot of insight to the CDS market nuances. It is interesting that Smith and Tavakoli consider Lewis to be a light weight. Yet, his book sales exceed theirs.

To get a notion of the size of the CDS market we need to look at these numbers. The size of our national economy this year is roughly $15 trillion. The whole world GDP is about $56 trillion. At the time of the 2008 failure, the size of the Credit Default Swaps (CDS) market was $64 trillion. The exposure at the time of the collapse was huge. The magnitude of the Naked CDS is not known, but is understood to be huge.

Given that the unregulated CDS underwriters were prone to not provide adequate capital reserves for defaults, there was a massive liquidity problem, hence the government had to step in and bail out the likes of AIG and banks who wrote these products.

The whole CDS market is described as being part of the Casino Gambling image in the financial markets

Current Status

The Dodd Frank Bill has a moderate approach for Derivatives Regulation. However it is up to the regulators for implementation and the banks are attempting to minimize the impact of regulation. This is documented by two recent NYT articles.

It’s Not Over Until It’s in the Rules

A Secretive Banking Elite Rules Trading in Derivatives

A short summary of the above articles is that the big banks are attempting to save their Oligopoly through the Risk Committees of the Clearing Houses. This is being done by imposing high capital reserve requirements for participants. This has the effect of limiting competition which limits price competition and transparency. The elephant in the room is the risk committee’s saying certain derivatives are to complex to be cleared. This gets us right back to where we were in the financial crisis. Over the Counter non clearing house products are the most profitable and open to risk.

In the spirit of Brooksly Born regulation, It has been proposed that Derivatives be run using a Clearing House or a Exchange Trading Requirement.

From The Economist:

Clearing House: A clearing requirement is a requirement that all eligible derivatives be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member’s failure, netting clearing members’ trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current OTC derivatives markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in OTC derivatives

Exchange Trading: An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as “boards of trade”)..The exchange is just the trade execution venue (think NYSE vs. Nasdaq). The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.”

The clearing house is obviously the better because it brings a degree of financial integrity and transparency. It certainly is the more expensive of the options, but its cost  is minuscule when we think of the financial collapse.

However based on the articles above, it is clear that the big bankers are attempting to preserve their oligopoly in terms of the CDS market. They also want to preserve the option to take the market back to the opaque high risk environment because of profit opportunities.  The Opaque Over the Counter market is the biggest threat to the stability of the market

In Dodd – Frank, the CFTC and SEC have co-jurisdiction The CFTC commission seems to be moving to the bankers view. SEC has been relatively quiet on this subject

We need to remember that Mary Schapiro (SEC)  and Gary Gensler (CFTC) were part of the problem before the 2008 Financial Crisis. It remains to be seen how well they address the problem. Will they do the right thing or are they financial industry moles?

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35 Comments on “Derivatives – The Dark Market”

  1. Dee says:

    Nice article. Thanks for posting.

    Will this be on the test?

    • fiscalliberal says:

      Only in the sense that lifetime Experience gives you the test first and the lesson after. Hopefully the financial community can learn from this but they haven’t yet

    • Nice article. Thanks for posting.

      Will this be on the test?

      What Dee said! Welcome to the frontpage, Larry. I’m going to re-read this and sharpen my pencils for the pop quiz 😉

    • Seriously says:

      That’s funny. 🙂 Great post, fiscalliberal. Congrats on becoming a front pager.

  2. fiscalliberal says:

    I just want to take the time to thank Dakinkat for her help in providing a forum where this stuff can intelligently be discussed in a more “lay” fashion. Also for her patience, suggestions and help in getting this published.

    One of my hopes with the series of articles I write is that we generate talking points to be used in supporting rational economic thought. Opinions substantiated with facts. To often we have heard he right wing call for less government. In the article I point out how we got less government under George Bush and the financial industry collapsed. The question has to be asked – is less government sustainable. No!

    So let us continue learning from our Prairie Populist Economist and also each of us enhance the discussion with help in writing articles.

  3. cwaltz says:

    The entities that brought us to this point haven’t learned a thing- except that they can use the rest of our money as insurance against risk. All you have to do to understand that is listen to the right side of the aisle and their chorus of regulation is bad.

    I really wish the left would buy a clue and start repeating over sand over. The 16th century mercantilists were right. In trade there is a winner and a loser. ZIn trade there is someone who is exploited and someone who does the exploiting. There is no win-win. Look at wages and look at productivity, and then look at profitability. If this were win-win EVERYONE would be benefitting from growth. Instead we have a select few who benefit regardless of the conditions. That isn’t a free market. It’s a rigged market. And the only solution for a rigged market is REGULATION.

    It’s past time to put the free market unicorn out to pasture.

    • dakinikat says:

      The foxes are in charge of the henhouse in congress now. Some of the worst offenders of believing the myth are in charge of key committees. They just seem intent on bringing the country down to prove their ideological creds.

      • dakinikat says:

        Actually, I think that the Republican party is pretty intent on destroying the country as we know it. They seem to want to set up some alternative like a theocracy. It’s like they want to be as bad as Iran by being the Anti-Iran. Scary, scary.

        • Pilgrim says:

          Yes, because Christian fundamentalism is as worrisome as Islamic fundamentalism, and it seems to be growing like a weed in the U.S.

          Theocracy, here we come.

          Margaret Atwood wrote The Handmaid’s Tale a few years ago, and it almost could seem far-fetched, but not when one considers the abortion hysterics, with their big supporters in government.

          • cwaltz says:

            Groups like Hamas and Al Queda have traditionally been fuelled by inequity. The idiots in charge are creating a breeding ground for these type of groups with their policies. You can’t FORCE people to believe in anything. What you can do is force them to push back forcefully.

        • cwaltz says:

          They’re idiots then. The muslim community is growing at a much quicker rate then Christianity. Not only that but the poverty they are creating with their policy has been fuel to that very community in other countries. They better be very careful what they wish for.

          • dakinikat says:

            Actually, I know a lot about Shariah compliant finance and banking and the model is not only viable it’s more moral imho. It emphasizes the moral use of sharing stored up purchasing power and decries speculation. I think that’s why we’re on a ‘crusade’ against it now.

            The prophet teaches that usury is bad–which is based in the same old testament stuff–and also that ‘hoarding’ money is bad. The Qu’ran basically teaches the community to not do either because money hoarding doesn’t help any one in the community. Shariah compliant stock exchanges, etc. are based in getting money to small entrepreneurs who have the ability and ideas but not the capital and freeing people with money of the sin of ‘hoarding’. It also is working on getting access to partnerships in businesses to small people. Instead of lending people money, charging them fees and exorbitant interest rates, what you do is join in partnerships with entrepreneurs and share in their profits and losses. It’s the basics of the Grameen bank. Every one also has to allot a certain part of their income and profits to the care of widows and orphans. You’re also not allowed to gamble or speculate because that offends Allah. Capital is only moral when its used for the betterment of the community. It’s like the Buddhist concept of ‘right livlihood’.

            I can understand why we’re demonizing the Muslim faith these days. Shariah compliant finance and banking would strip all those profits right out from under Wall Street. Hell, I’d be the first in line to put my money in a Shariah compliant bank, frankly.

          • cwaltz says:

            . Some of The “Christianity” preached by the Repun party isn’t even recognizable as Christianity by anyone who actually took the time to read the New Testament. I mean where in the Bible did Jesus preach, “let children go hungry so that the rich can have a tax break.” Sure they are for bringing children into the world, but it isn’t like once they’ve brought them into the world they’re concerned with the child’s needs. No then the rallying cry is “welfare moms stealing your hard earned tax dollars!” There is no way this brand of Christianity will hold up to scrutiny.

            Believe it or not the Bible ain’t keen on borrowing either. I frequent quite a few Christian frugality sites that are run by some pretty thrifty people intent on living within their means. On one site the person who owns the site just plunked down cash for their home. The spouse went through law school without a single student loan. It’s one of the reasons I kinda giggled when I heard that SAHM weren’t financially savvy. Stretching money is a full time job for alot of these women. They’ve managed to create clout in the business community. Some of them have companies literally begging to send them their products to create exposure. It’s pretty funny.

          • dakinikat says:

            I know. The Shariah law is exactly what orthodox Jews use also. I have a post coming up to talk about another example of that hypocrisy.

            The most beautiful part of the new testament to me was always the Beatitudes and I never hear any of that come from the mouth of a Republican or any of these outraged “they declared war on christmas” types … greed is their religion and they have plenty of idols out there in material things like their electronics gadgets

          • dakinikat says:

            As far as I can tell, this is supposed to be how christians get to “the Kingdom”. Starving the beast isn’t one of them.

            “Blessed are the poor in spirit,
            for theirs is the kingdom of heaven.

            Blessed are they who mourn,
            for they shall be comforted.

            Blessed are the meek,
            for they shall inherit the earth.

            Blessed are they who hunger and thirst for righteousness,
            for they shall be satisfied.

            Blessed are the merciful,
            for they shall obtain mercy.

            Blessed are the pure of heart,
            for they shall see God.

            Blessed are the peacemakers,
            for they shall be called children of God.

            Blessed are they who are persecuted for the sake of righteousness,
            for theirs is the kingdom of heaven.”

            Gospel of St. Matthew 5:3-10

            I always had a habit of sticking with Matthew’s gospel and sort’ve ignoring almost everything I’d read after that with maybe the exception of James and the log in the eye thing.

  4. Dak – i think Macro Economics likes to hype the Comparative Advantaage dogma on trade. In the same breath, is Full Employment ever discussed. Does anyone talk about the benefits of keeping everyone employed?

    Some how we never get to the whole picture on these subjects. I would guess that is the result in our being the dominant economy post WW II because all the competition was bombed out.

    However we certainly have a different story now and economists are going to have to start addressing our declining economy releavite to the world. The rise of commodities due to other economies is a start of that discussion.

    • dakinikat says:

      The comparative advantage model is old school now. Full employment is one of the goals of the macro-models.

    • cwaltz says:

      Heh, we’re gonna be an “investment” economy. Who needs stinkin’ employment? I seriously believe that there were / are people within the financial community who don’t see the potential problems with this picture. They don’t seem to get being reliant on other communities for commodities and what not comes at a really high cost. We ought to be doing everything we can to be able to operate independant of the global economy while functioning within it. I don’t think the folks in DC get that or are creating an environment that nurtures that concept. We’re setting ourselves up for lots of problems later on down the line when scarcity will come up absent innovation. It’s scary.

  5. dakinikat says:

    How Allstate Used Sampling To Confirm BofA/Countrywide Lied About Virtually Everything In Selling Mortgages

    A few days ago, news broke that MBIA was allowed to use statistical sampling in its ongoing Bank of America fraud lawsuit. This happened despite the Countrywide acquiror’s loud protests. And now, courtesy of today’s brand new lawsuit against BofA (and Agent Orange himself) filed by Allstate, in which the insurer “seeks unspecified damages, alleges fraud, negligent misrepresentation and violation of U.S. securities laws” we know just why Bank of America was so very against allowing sampling to be used by plaintiffs. According to the full report (pdf attached below), Allstate has determined that Bank of America misrepresented virtually everything in its prospectuses: from the percentage of owner-occupied properties reped in prospectuses (about a 10% differential), to the LTV thresholds on represented loans (both at the 90% and 100% threshold), while inbetween finding willful and malicious intent to defraud and deceive. We are confident that none of this, however, will result in a prison sentence for Mozillo, as laws in America are meant to be broken by anyone who can demonstrate an LTV more than 100,000% or have more than $100MM in annual income (including that derived from golden parachutes).

    • It looks like the article you reference substantiates the point made by Chris Whahlen in the video I sent you. BofA is insolvent because of its mark to model and thier customers forcing them to buy back the securities.

      This is kind of big if these types of things continue substantiating Whalens contention that BofA needs to be restructured. Especially now that Dodd Frank gives the governement the tools to force that. Might be the first test of Dodd Frank

      • dakinikat says:

        BOA needs to be busted up and sold off. Maybe the Wikileaks cables will provide enough public outcry to light a fire under those congressmen still bought off by the FIRE lobby. Unfortunately, the new heads of the relevant House committees think they exist to serve banks.

  6. fiscalliberal says:

    The interesting thing is, how can we expect conduct business if the government does not prosecute fraud. The whole system is predicated that least there is a responsibility to do the right thing.

    Unless Obama (the government) sets this tone, people will be reluctant to do business. Next will be non enforcement of contract law.

    • Sima says:

      This worries me too. Someone has to guard the henhouse and that used to be the government.

      Was it this bad in the 1880s and early 1900s too? I need to do some reading and find out.

  7. Minkoff Minx says:

    I just want to welcome fiscalliberal to the Front Page. I am very excited and proud of the additional front pagers to the Sky Dancing Blog. Thank you for this post. I will come back to it again like Wonk said 😉

  8. CinSC says:

    I made my own personal investment in mega-millions today… and it probably has a better chance of paying off than alot of the those derivatives.

    The numbers showing that the cds market exceeded the world gdp still astound. We really need to get to the place where these are traded on a market like stocks, shedding light on it all.

    • dakinikat says:

      Yup, that would help with transparency and pricing. Problem is that these investment banks make money off of insider information, information asymmetry, fees, and marketing. It’s not in their best interests to have a Charles Schwab model of risk management. Simple options, calls, puts, etc like they have on forex or commodities aren’t that difficult to deal with and so these guys are unnecessary. They need the unique complex ones to drive their fees income.

      • CinSC says:

        I’m all for rewarding proprietary models and systems. Somehow there needs to be a standard for documentation. I used to love digging thru my old employers’ annual report and actually figuring out what the company was really up to. Often quite a different story than what the glossy front pages described.

  9. grayslady says:

    Welcome to the front page, fiscalliberal! I’m going to come back and read this thoroughly in the morning when my head is a little clearer.

  10. Further thought on the Allstate case. I wonder if the judges are just starting to get a little tired of the financial community and their antics. Hence the statistical ruling in favor of allied.

    If this case is successfull and fraud is shown, how long will the Obama (Holder) administration be able to continue ignoring the obvious fraud. Truely, we have to have laws on the books that address this type of stuff.

    This has all the atmosphere tone of that which preceeded Bear, Lehman and AIG collapses.

    • dakinikat says:

      I can’t imagine how long. There have been so many cases of violation of the Sherman Anti-trust Law and fraud laws, that it’s getting obvious that they’re overlooking a lot for their investment bank buddies.

  11. Sima says:

    Welcome FL! And thanks for this post. It explains a lot, and is easy to understand. Bravo!

    I guess the one big thought that strikes me is how close all this is to gambling. In fact it can even be rigged gambling. I know that the stock market is very similar to gambling, but CDS seem very much closer, like, as you said, taking out insurance on and betting that your neighbor’s house will or will not go up in flames. And all of us poor investors, whether we knew it or not, were the chumps in this.

    I found out today I have 134 shares of BofA in my portfolio. I thought it’d all been sold. So, I guess I’m selling it tomorrow!