Derivatives, the Financial Crisis, and Regulation

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Derivatives, the Financial Crisis, and
Regulation
David MarshallSenior Vice President Federal
Reserve Bank of Chicago
Financial Regulation Who, What, Where, and
Why? Burridge Center for Securities Analysis and
Valuation November 6, 2009
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OTC derivatives and the crisis

• Warren Buffett in 2003 labeled derivatives as
  financial weapons of mass destruction.
• Myron Scholes the solution is really to blow up
  or burn the OTC market, the CDSs and swaps and
  structured products and let us start over
  (Bloomberg, March 6, 2009)
• Maxine Waters introduced a bill in July 2009 to
  ban credit-default swaps
• She said they permitted speculation responsible
  for bringing the financial system to its knees
• George Soros credit- default swaps are toxic
  and a very dangerous derivative
• Christopher Cox, SEC chairman The virtually
  unregulated over-the-counter market in
  credit-default swaps has played a significant
  role in the credit crisis. (Bloomberg, Nov. 14,
  2009)

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Key Driver Fall in residential real estate
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Uncertainty as Multiplier Supply of Credit

• The fall in wealth represented a huge loss to the
  economy
• Key multiplier of this shock uncertainty
• uncertainty about the magnitude of these losses
• uncertainty about the allocation of these losses
• Uncertainty shrinks the supply of credit
• Uncertainty about counterparty creditworthiness
• Balance sheet uncertainty

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Uncertainty as Multiplier Runs

• Runs on financial institutions more likely when
  uncertainty is high
• Runs by unsecured short-term creditors
• Bank runs by depositors IndyMac, Wachovia,
  Northern Rock
• Non-bank runs by unsecured creditors ABCP
  conduits, SIVs
• Runs by secured creditors failure to roll over
  repo funding
• Runs by brokerage customers
• Customers deposit collateral with prime brokers
• Prime brokers rehypothecate collateral pledged
  to secure funding
• A customer switching prime brokers expects return
  of their collateral
• If enough customers switch brokers, the original
  prime broker may have insufficient collateral to
  pay off the customers.

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OTC derivatives market as a source of uncertainty

• Derivatives play vital economic role
• 60.5 of nonfinancial firms worldwide use
  derivatives
• 94 of corporations in the Fortune Global 500 use
  derivatives
• Study Use of derivatives generally reduces risk
  and adds value
• Allows risk to be transferred to those best able
  to bear it
• The CDSwap market grew dramatically over the last
  5 years

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OTC derivatives market as a source of uncertainty

• CDSs provide a pathway to transmit risk
  associated with house price declines in
  unpredictable ways
• CDSs constitute side bets on the value of
  mortgages
• Increases the set of parties potentially exposed
  to house price declines
• AIG
• No natural exposure to house prices.
• Financial products division took on huge
  derivatives exposure via CDSs on MBSs.
• The extent of their exposure not widely known
  until a month before the collapse.
• Similar dynamic for monoline insurers
• MBIA, Ambac, FGIC

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CDSs transmitted risk from banks to insurers
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Chains of counterparty credit exposure

• OTC market is dealer market
• There is a chain of dealers between two end-users
• Notional Overhang
• Notional exposure large compared to end-user
  needs
• Multiplies exposure to potential dealer defaults

End-user A buys protection
Dealer 3 sells to 2 and buys protection from
end-user B
End-user B sells protection
Dealer 1 Sells to A and buys from 2
Dealer 2 sells to 1 and buys from 3
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Counterparty Credit Risk

• What happens if Dealer 3 fails?
• Default of dealer 3 causes loss to dealer 2,
• If, as a result, dealer 2 defaults, loss is
  transmitted to dealer 1
• This, in turn, exposes end-user A.
• The chain of notional exposures magnifies
  exposure to primary risk (housing)
• Transforms primary risk into counterparty credit
  risk

End-user A buys protection
Dealer 1 Sells to A and buys from 2
Dealer 2 sells to 1 and buys from 3
Dealer 3 sells to 2 and buys protection from
end-user B
End-user B sells protection
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Counterparty Credit Risk

• In the exchange-traded markets, counterparty
  credit risk is mitigated by centralized clearing
• Central counterparty (clearinghouse) stands as
  buyer to every seller and seller to every buyer
• Margin posted to clearinghouse
• Daily (or twice daily) marking to market.
• In the OTC market, some protection provided by
  collateralization
• In many cases positions in the OTC markets were
  undercollateralized.
• AAA-rated writers of CDSs not required to post
  initial margin collateral.
• Left counterparties with insufficient protection.

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Vulnerability of clearinghouses to illiquidity

• Central clearing only works if sufficient funds
  are available on a precise time table.
• Clearinghouses and their members depend on
  intraday credit to ensure that payments are made
  according to this time table.
• In a liquidity crisis, can we be sure that this
  liquidity will be available within this tight
  time frame?
• In the aftermath of the Lehman bankruptcy,
  liquidity became very tight, and banks became
  very reluctant to provide intraday credit.

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Proposal 1 Systemic risk regulator

• Financial Stability Improvement Act of 2009
• Released jointly by Treasury and House Financial
  Services Committee
• Empowers Financial Services Oversight Council
• Includes Treasury Secretary and Fed Chairman
• Monitors risk accumulation and risk transmission
  pathways
• Advantages
• Centralized accountability for tracing risk
  propagation
• Eliminates regulatory gaps
• Potential problems
• Council must have clearly defined role.
• Not on my watch!

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Proposal 2 Central clearing of OTC contracts

• The OTC Derivatives Markets Act of 2009
• OTC market under joint supervision of SEC and
  CFTC
• Requires that most standardized contracts be
  traded on exchanges and centrally cleared
• Non-cleared contracts subject to minimum
  collateral
• Centralized trade information repository
• Advantages
• Mitigates counterparty credit risk
• Central counterparties dont rehypothecate
  collateral
• Enhanced transparency
• Multilateral netting
• Potential problem Determining whats clearable.
  
• To require clearing of an unclearable contract
  could place the central counterparty at risk.

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Multilateral netting via central clearing
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Proposal 3 Fed credit to clearinghouses

• Payment, Clearing, and Settlement Supervision Act
  of 2009
• Gives clearinghouses and other systemically
  important financial market utilities (FMUs)
  access to the Feds discount window
• FMUs would also have Fed accounts, direct access
  to Fedwire
• Fed would exercise oversight
• Advantages
• Creates known rules governing the Feds liquidity
  backstop.
• Grants Fed sufficient oversight to ensure that
  Fed liquidity is only used as last resort
• Potential problems
• Moral hazard
• Implicit subsidy to CCP