Credit Derivatives Remain 'Largest' Systemic Risk

The markets for over-the-counter (OTC) credit default swaps (CDS) and collateralized debt obligations (CDOs) can never overcome their opaque and complex nature; further, they were designed to hoodwink potential purchasers and to obscure their essentially fraudulent nature, according to risk analyst Christopher Whalen.

CDS and CDO's provide supersized financial returns to the Wall Street dealers who construct them while imposing a tax on the financial system, the global economy and the public, Whalen contends. Rather than spread risk, as claimed, they are the chief source of systemic risk and Congress should ban them forever, he recommends. All other OTC derivatives need to be brought under the regulation of the Commodity Futures Trading Commission, he adds.

By Robert Stowe England

July 9, 2009
(Updated July 10, 2009)

As Congress tackles the issue of regulatory reform of the financial system, the most important thing it can do is to ban over-the-counter credit derivatives because they pose “the largest source of systemic risk in the global financial markets.”

That is the message from Christopher Whalen, the co-founder and managing director of Institutional Risk Analytics, a Los Angeles publisher of risk ratings and provider of financial analysis and valuation tools.

Whalen gave his views in testimony June 22 and follow-up responses provided to questions from the Senate Committee on Banking, Housing and Urban Affairs, both of which can be found at this link:

Whalen’s testimony blasted the unregulated over-the-counter (OTC) market for credit default swaps (CDS) -- which brought down AIG last fall and cost taxpayers hundreds of billions of dollars in bailouts so far - as well as the market for Collateralized Debt Obligations (CDOs).

A credit default swap is a counterparty agreement in which the seller promises the purchaser to pay the remaining interest and principal on the debt if there is a default. In return, the purchaser makes regular payments to the seller to provide the insurance against default. See a definition at this link:

A collateralized debt obligation is a derivative security backed by a pool of other bonds and loans. It pays a stream of income to the purchaser and is divided into tranches with differing levels of risk. See definition at this link:

Whalen argued that unregulated credit derivatives, which represent a big slice of the world’s huge OTC derivatives markets, are based on deceptive contracts sold to credulous buyers who are participating in a gaming activity and not investing.

“A situation where one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans as a fraud,” Whalen told the Senate Banking Committee.

Whalen laid out a roster of indictments against big Wall Street derivatives dealers.

“It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system,” the analyst told the Senate panel.

“Simply stated, CDS and CDO markets currently are parasitic,” Whalen said. “These markets subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.”

“Seen in this context, AIG was the most visible ‘sucker’ identified by Wall Street, an easy mark that was systematically targeted and drained of capital by [JP Morgan Chase, Goldman Sachs] and other CDS dealers, in a striking example of predatory behavior,” Whalen said.

AIG is not alone. CDS contracts and CDOs constitute a large share of the toxic waste assets on the books of financial institutions in the United States and around the globe. Write-offs and mark-downs of these assets have weakened the financial system and contributed to a global recession.

Risk analysts have argued that the pricing of CDS contracts is not sufficient to cover any claims and indeed that in the case of AIG, they never intended to pay them. See article at this link cited by Whalen in his testimony:

Geithner's Testimony

On July 10 Secretary of the Treasury Timothy Geithner was the sole witness at a joint hearing of the House Committee on Financial Services and the House Committee on Agriculture. The hearing focused on a potential legislative and regulatory proposal on coordinating regulation of OTC derviatives that is set to emerge from the Securities and Exchange Commission and the Commodity Futures Trade Commission (CFTC).

See this link for Geithnner's prepared testimony:

The industry favors a clearinghouse approach for credit derivatives, which Treasury is also backing. See story at this link:

Here is a press release from this past spring describing recent research by the TABB Group of Westborough, Massachusetts, on trends in the credit default swaps market around the globe:

A Behemoth Market

The systemic risk from the OTC credit derivatives is partly due to its sheer size.

According to the Bank for International Settlements, the notional value of OTC derivatives in December 2008 stood at $592 trillion, with a gross market value outstanding of $34 trillion. Credit and equity derivatives represented $48.4 trillion and had a gross market value outstanding of $6.8 trillion.

If one just looks at CDS only, their notional value is greater than all the money invested in the U.S. stock market, American mortgages and U.S. Treasuries combined. Indeed, they are almost as large as the output of the entire world. See information at this link:

While notional values certainly overstate the exposure, it is hard to get a handle on the real exposure that the financial system has to credit derivatives. A June 26 estimate from the U.S. Office of the Comptroller of the Currency (OCC) sets the net credit exposure of U.S. commercial banks only (many contracts are held by hedge funds and other non-bank firms) at $695 billion for the first quarter of 2009, a 50 percent increase over the exposure level in the fourth quarter of 2008.

U.S. banks also face a potential future exposure at $723 billion for a total credit exposure of $1.418 trillion, according to the OCC.

Deceptive and Unfair

In his criticism of the OTC derivatives market, Whalen was careful to distinguish between two very different types of derivatives markets, only one of which he sees as legitimate.

On the legit side, there are derivatives contacts that are based on a clear, visible cash market, Whalen explains. This includes, for example, currency swaps, interest rate swaps, and natural gas swaps. “Both buyers and sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection,” Whalen stated.

However, on the other hand, in the case of another type of contract – those for CDS and “more obscure” CDOs – “the basis for the derivative is non-existent or difficult/expensive to calculate,” he stated.

Part of the pricing difficulty arises from that fact they are based on models developed by their creators. “The buyer of CDS or CDOs has no access to such models and, thus, really has no idea whatsoever how the dealer values the OTC derivative,” Whalen testified.

More importantly, Whalen explained, the dealer models “are almost always and uniformly wrong and are, thus, completely useless to value the CDS or CDO.”

Whalen argued that most CDS contracts and structured financial instruments are “deceptive by design” and “deliberately fraudulent instruments for which no cash basis exists” and for this reason should be banned.

“If we as a nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives,” he said, “then how can we expect our financial institutions and markets to be safe and sound?”

Whalen contends that the fundamental understanding that makes financial markets work, and which has been built into financial law and regulation, rests on the principle that “equal representation under the law [goes] hand-in-hand with proportional requital.” By that, he meant “that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain.”

What Needs to Be Done

In response to a question about how to modernize oversight of the OTC derivatives market,
Whalen laid out in his written resonse what he thought Congress should do to address the problems in the derivatives market.

First, he said, Congress should require that OTC contracts be subject to The Commodity Exchange Act (CEA) of 1936, a step that would bring them under the oversight of the Commodity Futures Trading Commission (CFTC).

Congress should also instruct the CFTC to begin a systematic review and rule-making process. The purpose would be to either conform OTC markets to minimum standards of disclosure, collateral and transparency. Or, require that the OTC contracts be migrated onto organized, bilateral exchanges.

“It is time for Congress to right the wrong done over a decade ago to [former] Commissioner Brooksley Born and her colleagues at the CFTC,” Whalen wrote.

“This wrong was committed in part by the Congress and part by then-Treasury Secretary Larry Summers, and then-Fed Chairman Alan Greenspan, and former Treasury Secretary Robert Rubin, among others, who all worked together to effectively block action that would have subjected OTC contracts to the full supervision of the CFTC.”

Whalen also faulted Summers, Greenspan and Rubin for vilifying Born and others at the CFTC.

Second, Congress should admit it erred in 2000 by blocking CFTC regulation of OTC derivatives. That decision set the stage for an explosion in the derivatives market, according to the risk analyst.

Third, Whalen urged that Congress, after bringing OTC markets under the oversight of the CFTC, should “take further time for hearings and fact finding to consider what other changes should occur in terms of the law and the operational structure of the SEC and the CFTC.”

Finally, Whalen explained why the above prescription does not work for credit derivates and why they should be banned: “It is probably not possible to move” the market for CDS and complex structure assets to an exchange.

“Because CDS contracts generally do not have a cash market or basis upon which to draw for the purpose of valuation, as a matter of law regulation, these investments are entirely speculative, unsuitable for most banks and investors, and thus should be banned entirely.”

Whalen’s proposal to bring the OTC derivatives market under the wing of the CFTC is also a slap at the potential ability of the Federal Reserve Board and the Treasury to oversee systemic risk.

Indeed, the risk analyst warned Congress that as it set about to reform financial regulation, members should ignore “the views of existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury,” since their views are “large duplicative” of JP Morgan Chase, Goldman Sachs and the other larger OTC derivatives dealers who have essentially “captured” their regulators.

Whalen argued against the need for a systemic risk regulator.

Systemic risk “is a function of inefficient markets and opaque, illiquid financial instruments such CDS and complex structured assets.” If Congress imposes regulation on the OTC derivatives market, the “perceived need for a systemic regulator will disappear,” Whalen wrote.

“All that will be left to do then is to “celebrate the end of one of the darkest, most alarming periods of speculative mania seen in many generations,” Whalen wrote.

Whalen also attacked the idea that the unregulated derivatives market is “innovative,” a view former Fed Chairman Alan Greenspan once advocated.

Imposing appropriate prudential and legal limitations on OTC derivatives would have enormous benefits for investors in terms of better pricing, increase transparency regarding market and liquidity risk and improved surveillance and oversight by regulators,” Whalen wrote in response to a question from Senate panel about how his proposals would affect different market participants.

The regulation of OTC derivatives will “limit predatory behavior by lenders and major Wall Street dealer firms,” Whalen argued. “If you do not allow overly-complex financial instruments to exist in the first place, then the Congress will effectively limit systemic risk in financial markets.”

Doom for Derivatives Dealers?

Ultimately, the regulation of OTC derivatives will take away from JP Morgan Chase and Goldman Sachs the ability to make outsized profits on credit derivatives, Whalen explained in his written responses.

“Why then are the large banks, led by [JP Morgan Chase], engaged in such a desperate battle over the reform of the OTC derivatives market?” he asked. “For the world’s largest banks, the OTC derivatives market is the last remaining source of supra-normal profits,” Whalen told Congress.

“Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by [JP Morgan Chase, Goldman Sachs] and the remaining legacy OTC dealers, the largest banks cannot survive and must shrink dramatically,” Whalen wrote.

“No matter how good an operator of commercial banks [JP Morgan Chase chief executive officer] Jamie Dimon may be, his bank is doomed without its near monopoly in OTC derivatives,” Whalen stated.

“Seen from that perspective, the rescues of Bear Stearns and AIG were meant to protect not investors nor the global markets, but rather to protect [JP Morgan Chase, Goldman Sachs] and the small group of dealers who benefit from the continuance of their monopoly over the OTC derivatives market,” Whalen wrote.

Administration Proposal a ‘Canard’

Whalen also spoke against the Obama Administration’s proposal for financial market regulatory reform.

“Americans have historically stood against efforts to reduce transparency and make markets less efficient – but that is exactly how this Committee should view proposals from the Obama Administration and Treasury to ‘reform’ the OTC derivatives markets,” Whalen testified.

The risk analyst called the Administration’s proposal “a canard” because it does not reform the market but instead preserves it essentially as it is.

The Administration’s OTC derivatives market proposal is “an attempt by the White House and the Treasury Department to leave in place the de facto monopoly over the OTC markets by the largest dealer banks, led by [JP Morgan Chase, Goldman Sachs] and other institutions,” Whalen wrote.

“For example,” he continued, “the centralized clearing model proposed by the Treasury has some notable attributes, but still leaves the OTC markets under the complete control of the dealer banks, with little public disclosure of prices, no transparency, and no accountability to other dealers and market participants.”

“The proposal,” he added, “to require centralized clearing does not address the issues of pricing, basis risk and transparency.”

Copyright © 2009 by Robert Stowe England

Copyright 2009© by Robert Stowe England


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