Because Ignorance is not Bliss

Submitted by Timmy the Wonder Dog on Mon, 10/06/2008 - 10:33pm. Tags:

First and foremost, talking points don't make an arguement.

. . . In 1998, the CFTC began to take steps suggesting the agency was on a path to regulating OTC derivatives at the expense of other Federal regulators. This change of regulatory direction was disconcerting to the markets, given the fact that the CFTC had chosen not to regulate these transactions since 1993. Beyond this jurisdictional question lay a more problematic systemic issue. Market participants feared that if the CFTC asserted its exclusive jurisdiction over OTC derivatives, these transactions could be deemed illegal off-exchange futures contracts under the CEA, allowing a court of law to declare the contracts null and void. Such a ruling could have reverberated throughout the entire OTC derivatives market by allowing parties to walk away from unprofitable OTC derivative obligations. It became imperative that the legal and jurisdictional cloud surrounding these transactions be dissipated to keep this marketplace thriving and onshore.

In November 1999, the President’s Working Group on Financial Markets (PWG), which consisted at the time of Federal Reserve Board Chairman Alan Greenspan, Treasury Secretary Laurence Summers, Securities and Exchange Commission Chairman Arthur Levitt and CFTC Chairman William Rainer,unanimously proposed to Congress clarifying the jurisdiction of the CFTC by excluding certain OTC derivatives from its oversight. In determining whether the CFTC should have regulatory authority, the PWG looked to whether the products were traded by retail customers, whether the products were susceptible to price manipulation and whether the participants were not otherwise regulated. Unless one or more of these attributes were present in these markets, the PWG believed that there was no policy justification for providing the CFTC with oversight. Congress ultimately incorporated this reasoning in the CFMA by including several different exclusions that removed these products from the CFTC’s jurisdiction. . . .

Statement of Walter Lukken
Commissioner
U.S. Commodity Futures Trading Commission
to the FOW Trade Mission –Shanghai

November 21, 2003

Please read the entire article and then we can talk about pork bellies.

Some additional background information on ISDA is probably warranted but...

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

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So... (#127373)
by franklin on Tue, 10/07/2008 - 6:04am

do you believe that some regulation of derivatives like CDSs would have mitigated or prevented the current crisis? If so, would that protection have been more valuable than the damage caused by the regulation? (seems like it would have been possible to write legislation or whatever to get around voiding existing contracts/obligations)

I'm not arguing with the bipartisan nature of passing CFMA, though.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( )
since the crisis wasn't driven by the use of derivatives (#127487)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 2:40pm

I would answer no.

What protection are you recommending?

Finally, I'm happy that the CFMA myth and legend has been put to rest.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Protection (#127494)
by franklin on Tue, 10/07/2008 - 2:47pm

How about a reserve requirement if writing a CDS? How about some public disclosure, a la what is being debated by the SEC, like a qualitative description of what the CDS was bought for, how it will hedge risk, what gains it will hopefully produce, etc., by public companies? These would probably right there make them much safer and more sane instruments of risk management, and limit the speculation.

I'd question you on dismissing CDS' role in the current crisis. Not being able to cover potential CDS obligations was a main reason for the failures at both Bear and AIG. Additionally, the hedge fund world is set to implode should CDSs fail in general.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
If you take a look at the back of the 10-K of any financial (#127504)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:01pm

entity it is there. Up front in the comments the institution will discus at length the efforts they take to manage their position.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
needs to be more specific than that (#127514)
by franklin on Tue, 10/07/2008 - 3:19pm

n/t

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
I will assume that you are not familar with 10-Ks (#127517)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:23pm

nt

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
that would be wrong (#127521)
by franklin on Tue, 10/07/2008 - 3:28pm

n/t

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
then, the table on derivatives (#127523)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:33pm

should provide the details to begin a conversationj but don't forget the footnotes.

and if you are dealing with insurance companies the statutory financials are exceptional.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Timmy, unless you amplify this answer and show (#127489)
by Bill White on Tue, 10/07/2008 - 2:42pm

all your work I assert that #127487 should be dismissed as not being neither persuasive or responsive to the issue at hand.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
but even if I took the time (#127505)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:03pm

to fully explain it to you, I doubt...

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Plenty of Democrats to blame as well as GOP-ers (#127381)
by Bill White on Tue, 10/07/2008 - 7:18am

Therefore we need to eradicate the notion that regulation is always bad, and eradicate it in a bi-partisan fashion.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
whoever said, regulation, per se, was bad (#127508)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:16pm

was wrong but the inverse is equally as true.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
I agree Timmy and that is why these topics need (#127518)
by Bill White on Tue, 10/07/2008 - 3:24pm

to be explained in a manner average folk can understand.

Good regulation is good;

Bad regulation is bad; and

Figuring out which is which can be difficult.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
but that hasn't been the conversation (#127522)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:30pm

see the conversations pursuant to Glass Stegal.

Bill, did you take the time to read the link? I believe you would find it interesting.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
A simple solution (#127359)
by Bill White on Tue, 10/07/2008 - 12:04am

Buyers and sellers of derivative products should be required to hold a genuine interest in the underlying debt that is the subject matter of the contract and aggregate totals issues cannot exceed a party's interest in the underlying debt OR adequate cash collateral to cover the bet is on hand.

Violations would be potentially subject to criminal prosecution.

Credit default swaps are how the magnitude of a handful of subprime mortgages was increased by many many multiples through layers of speculation.

The mother of all check kiting scams (on steroids) appears to be the simplest explanation.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( )
Credit default swaps are ... (#127483)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 2:34pm

really, please show your calculations because I'm pretty sure you don't know what you are talking about.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
It should be illegal to purchase a credit default swap (#127491)
by Bill White on Tue, 10/07/2008 - 2:45pm

unless you already own the instrument being hedged. Affiliated entity rules can be negotiated.

To hedge dubious debt (i.e. via CDS as insurance) is a legitimate business purpose.

Naked speculation via credit default swaps? Nope. It should be illegal.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
that certainly explains your difficulty with the subject (#127507)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:06pm

nt

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Surely you understand that "I'm the expert (#127510)
by Bill White on Tue, 10/07/2008 - 3:09pm

just do as I say" is a lousy way to get your way in a democracy.

The ability to explain complicated subjects in an easy to understand manner is a needful skill.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
after you blew the "tax credit" scenario (#127511)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:13pm

I would have to say you struggle with the fundamentals.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
If you choose to refuse to explain your points, (#127512)
by Bill White on Tue, 10/07/2008 - 3:15pm

no one can force you to. However, having those points thereafter ignored is the most likely consequence of your decision.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
two things (#127515)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:22pm

first, "Buyers and sellers of derivative products should be required to hold a genuine interest in the underlying debt that is the subject matter of the contract", doesn't make any sense, you cannot be both long and short is the same tangible asset.

second and related, holding a "genuine interest" is an expansive not a limiting phrase.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
My thesis is that credit default swaps are a legitimate (#127526)
by Bill White on Tue, 10/07/2008 - 3:38pm

mechanism to hedge debt. However, why should we permit such contracts if neither the buyer nor the seller of the CDS holds any interest in associated instrument?

How accurate is the following summary (wikipedia)?

A credit default swap (CDS) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default or on the occurrence of a specified credit event (such as bankruptcy or restructuring). The associated instrument does not need to be associated with the buyer or the seller of this contract.
Originally used as a form of insurance against bad debts, these instruments became a tool for financial speculation when the US Commodity Futures Modernization Act of 2000 specifically barred regulation of these trades.

Why should I be permitted to buy a credit default swap on Ford Motor Company corporate bonds (for example) if neither I nor the counter-party have a position in those securities?

If both the buyer and seller of credit default swap are strangers to the underlying debt instrument how is that deal different from taking InTrade positions on who will win the Presidential election? Or making sports book on whether the Rays defeat the Red Sox?

Farmers can and should be free to buy weather contracts (rainfall totals for example) at their own risk.

But unless such bets bear a reasonable relationship to the underlying reality (why should total issued credit default swaps be allowed to exceed the total face value of the associated debt instrument?) the potential exists for ridiculous levels of leverage which can rapidly collapse.

Thereafter, financial institutions that provide core liquidity needs for the global economy also should be prohibited from making such bets (except perhaps to hedge debt instruments they already own).

Okay, how is this wrong?

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
first, thank goodness you added neither. (#127529)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:45pm

Why should I be permitted to buy a credit default swap on Ford Motor Company... Well what if you have a material exposure to a major supplier of FMC and you want to hedge your position but more importantly who gets to decide.

What if you sell the FMC bond are you required to sell the swap?

I have more scenarios, if you wish.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
See my #127528, posted 3 minutes before #127529 (#127532)
by Bill White on Tue, 10/07/2008 - 3:49pm

Anyway, reading links offers this:

Futures and derivatives markets require a clear and predictable legal and regulatory system if they are to thrive, and the U.S is fortunate to benefit from such a foundation. On December 21, 2000, U.S. President Bill Clinton signed into law the Commodity Futures Modernization Act (CFMA). This bipartisan legislation was the most sweeping overhaul of the laws governing the commodity futures markets since the creation of our Commission in 1974. The Act’s broad design sought to bring greater competition, self-regulation and innovation to the various derivatives markets and to build a more predictable and calibrated regulatory apparatus for these instruments.

One of the principle motives behind this legislation was to clarify the legal status of the U.S. over-the-counter (OTC) derivatives market, which had become clouded over the years. When amended in 1974, the CEA required that the trading of all commodity futures contracts occur on a registered futures exchange under the exclusive jurisdiction of the CFTC. This regulatory structure was designed for the traditional “open outcry” or pit-trading exchanges to ensure that standardized futures trading occurred in specific physical locations under the watchful eye of a federal regulator. This regimented oversight also took aim at off-exchange “bucket shops,” in which individuals would fraudulently solicit funds from customers for futures trading and then pocket or “bucket” the money for themselves. Requiring that futures trading occur on a registered exchange among registered brokers under the CFTC’s exclusive jurisdiction was seen as revolutionary at the time and greatly minimized this illegal activity.

The U.S is fortunate to benefit from such a foundation?

When nearly a trillion dollars in emergency taxpayer funding is needed to shore up the system, something is broken and part of the price tag attached to the bailout should be a clear and cogent explanation of what went wrong and why and how do we prevent a repeat performance in the future.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
something is broken (#127537)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:53pm

my diary on Freddie and Fannie is coming

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
A great deal of calm careful explanation shall be (#127541)
by Bill White on Tue, 10/07/2008 - 3:57pm

needed to avoid accusations of an effort to lay smoke and shift blame.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
Fortunately, Timmy is just the dog for the job. nt (#127549)
by stillnotking on Tue, 10/07/2008 - 4:11pm

.

--

The other day I heard that ignorance and apathy are sweeping the country. I didn't know that, but I don't really care.

( | parent )
Calm careful explanation? A willingness to answer (#127552)
by Bill White on Tue, 10/07/2008 - 4:14pm

questions patiently? Are we certain we are talking about the same Timmy?

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
POSTING RULES!!!11!!ONE (#127556)
by stillnotking on Tue, 10/07/2008 - 4:25pm

nt

--

The other day I heard that ignorance and apathy are sweeping the country. I didn't know that, but I don't really care.

( | parent )
Actually, Timmy and I have been getting along rather well (#127559)
by Bill White on Tue, 10/07/2008 - 4:28pm

this afternoon.

And it appears Wikipedia actually does offer a good elementary introduction to credit default swaps.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
? (#127520)
by franklin on Tue, 10/07/2008 - 3:27pm

Many CDS buyers primarily buy them so they're both "long" and "short" on the same tangible asset. That's the whole point--you hedge the risk (going short) of owning the asset (going long).

Agreed on "genuine interest", though..that term could be tightened up a bit. I think what he's getting at (and forgive me if I'm wrong) is eliminating speculative CDS.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
Yep, "genuine interest" is a late night blog term (#127528)
by Bill White on Tue, 10/07/2008 - 3:42pm

Defining "genuine interest" would require nuance and study.

My question is if both the buyer and seller of a credit default swap are total strangers to the associated debt instrument, how is that different than buying weather futures or maybe placing a bet on the Rays versus Red Sox series?

Yes, I can see how an auto parts supplier might wish to purchase CDS on Ford Motor Company corporate bonds (especially if the supplier sells only to Ford) however unless someone is minding the store on the total exposure being created in the entire market, unexpected fluctuations can cause huge crashes.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
I'm with you... (#127534)
by franklin on Tue, 10/07/2008 - 3:50pm

I get where you're going, I think.

I actually don't see the harm in speculative or pure investment uses of CDSs. They just need to be regulated and disclosed appropriately. That way, it would take most of the idiots out of the equation.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
Those institutions which provide core liquidity needs (#127539)
by Bill White on Tue, 10/07/2008 - 3:55pm

to the overall economy shouldn't be placing bets with people who cannot pay those bets if they lose. Nor should an institution which provides core liquidity needs place a bet it cannot afford to pay, if it loses.

The magnitude of the total bets also matters.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
agreed (#127546)
by franklin on Tue, 10/07/2008 - 4:00pm

Which is why there should be a capital reserve requirement for CDS sellers and some form of public disclosure about the nature of and reason for buying and selling the contract.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
thank goodness for the Fed. (#127543)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:57pm

nt

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
And when the Fed is able to pour billions of dollars (#127548)
by Bill White on Tue, 10/07/2008 - 4:04pm

or even hundreds of billions of dollars into financial firms, being miserly with middle class and lower middle class mortgage lending and health benefits and unemployment compensation is a very short sighted position to take.

It risks populist uprisings that can kill this marvelous golden goose.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
What if you are long Brazilian sugar cane, (#127531)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:47pm

does a weather future make sense?

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
you hedge the risk (#127524)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:35pm

to be neutral

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Exactly (#127535)
by franklin on Tue, 10/07/2008 - 3:51pm

You're long and short on the same tangible asset.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
no you are neutral on the tangible asset (#127540)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:55pm

although you now have counterparty risk.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
Timmy, is the following example accurately portrayed? (#127545)
by Bill White on Tue, 10/07/2008 - 4:00pm

Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage the risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation.

Though the protection payments reduce investment returns for the pension fund, its risk of loss due to Risky Corporation defaulting on the bond is eliminated

. (However, the fund still faces counterparty risk if Derivative Bank becomes insolvent and cannot honor the CDS contract). If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
semantics (#127542)
by franklin on Tue, 10/07/2008 - 3:57pm

n/t

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
no, that is your position (#127544)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:59pm

you've locked in your price.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
agreed (#127547)
by franklin on Tue, 10/07/2008 - 4:03pm

but it's still semantics. You're both long and short, resulting in a neutral position. You stated you can't be both long and short in the same asset, and I wrote that, indeed, CDSs are used to be long and short on the same asset. It really is just semantics.

--

"The strongest drive is not love or hate. It is one person's need to edit another's copy."

( | parent )
I cannot because the actual figures are proprietary (#127488)
by Bill White on Tue, 10/07/2008 - 2:41pm

and you know that as well as I do. All such figures do need to be disclosed in public.

And that is why Paulson originally wanted NO review or oversight.

--

Fence post turtles -- They don't get up there by themselves, some moron had to put 'em there.

( | parent )
Paulson originally wanted NO review or oversight (#127506)
by Timmy the Wonder Dog on Tue, 10/07/2008 - 3:05pm

or he remembers how review and oversight screwed up Fannie and Freddie.

--

"Making sure your tires are properly inflated, simple thing, but we could save all the oil that they're talking about getting off drilling, if everybody was just inflating their tires and getting regular tune-ups. You could actually save just as much." Ob

( | parent )
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