Thursday, May 14, 2009
Regulatory Reform Over-The-Counter (OTC) Derivatives
The crisis of the past 20 months has exposed critical gaps and weaknesses in our financial regulatory system. As risks built up, internal risk management systems, rating agencies and regulators simply did not understand or address critical behaviors until they had already resulted in catastrophic losses. Those failures have caused a dramatic loss of confidence in our financial institutions and have contributed to a severe recession.
Last March, Secretary Geithner laid out new regulatory rules of the road to ensure we never face a crisis of this magnitude again. An essential element of reform is the establishment of a comprehensive regulatory framework for over-the-counter derivatives, which under current law are largely excluded or exempted from regulation.
As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response.
Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives.
Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad.
Objectives of Regulatory Reform of OTC Derivatives Markets
* Preventing Activities Within The OTC Markets From Posing Risk To The Financial System – Regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk:
* The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP):
o CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.
o For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.
* All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include:
+ Conservative capital requirements
+ Business conduct standards
+ Reporting requirements
+ Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts
* Promoting Efficiency And Transparency Within The OTC Markets -- To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes:
* Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:
+ Recordkeeping and reporting requirements (including audit trails).
+ Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.
# CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.
# CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators.
+ The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.
+ The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information.
+ The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.
* Preventing Market Manipulation, Fraud, And Other Market Abuses The Commodity Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and the SEC have:
o Clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses.
o Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets.
o A complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators.
* Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent.
* The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.
Saturday, May 9, 2009
Banks can't renegotiate mortgages that have been securitized and resold, even though they would be better off cutting their losses. For some reason, the option of doing so was apparently not taken into account when the assets were created. I don't know why, but at least it's something specific to point to as needing to be fixed.
Making commitments can be advantageous. A modern economy couldn't run without binding contracts. But option values are real too.
Friday, May 8, 2009
This amendment is already passed, but no corresponding amendment has been introduced in the House, according to http://www.huffingtonpost.com/2009/05/08/senate-passed-bill-would_n_199402.html. I don't know whether to support a House version.
TITLE __--COMPTROLLER GENERAL ADDITIONAL AUDIT AUTHORITIES
SEC. __X. COMPTROLLER GENERAL ADDITIONAL AUDIT AUTHORITIES.
(a) Definition of Agency.--Section 714(a) of title 31, United States Code, is amended by striking ``Federal Reserve Board,'' and inserting ``Board of Governors of the Federal Reserve System (in this section referred to as the `Board'), the Federal Open Market Committee, the Federal Advisory Council,''.
(b) Audits of the Board of Governors of the Federal Reserve System and the Federal Reserve Banks.--Section 714(b) of title 31, United States Code, is amended by striking the second sentence.
(c) Confidential Information.--Section 714(c) of title 31, United States Code, is amended--
(1) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; and
(2) by inserting after paragraph (1) the following:
``(2)(A) Except as provided under paragraph (4), an officer or employee of the Government Accountability Office may not provide to any person outside the Government Accountability Office any document or name described under subparagraph (B) if that document or name is maintained as confidential by the Board, the Federal Open Market Committee, the Federal Advisory Council, or any Federal reserve bank.
``(B) The documents and names referred to under subparagraph (A) are--
``(i) any document relating to--
``(I) transactions for or with a foreign central bank, government of a foreign country, or nonprivate international financing organization;
``(II) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, and open market operations; or
``(III) transactions made under the direction of the Federal Open Market Committee; or
``(ii) the name of any foreign central bank, government of a foreign country, or non-private international financing organization associated with a transaction described under clause (i)(I).''; and
(3) by striking paragraph (4) (as redesignated by this subsection) and inserting the following:
``(4) This subsection shall not--
``(A) authorize an officer or employee of an agency to withhold information from any committee or subcommittee of jurisdiction of Congress, or any member of such committee or subcommittee; or
``(B) limit any disclosure by the Government Accountability Office to any committee or subcommittee of jurisdiction of Congress, or any member of such committee or subcommittee.''.
(d) Access to Records.--
(1) ACCESS TO RECORDS.--Section 714(d)(1) of title 31, United States Code, is amended--
(A) in the first sentence, by inserting ``or any entity established by an agency'' after ``an agency''; and
(B) by inserting ``The Comptroller General shall have access to the officers, employees, contractors, and other agents and representatives of an agency or any entity established by an agency at any reasonable time as the Comptroller General may request. The Comptroller General may make and retain copies of such books, accounts, and other records as the Comptroller General determines appropriate.'' after the first sentence.
(2) UNAUTHORIZED ACCESS.--Section 714(d)(2) of title 31, United States Code, is amended by inserting ``, copies of any record,'' after ``records''.
(e) Availability of Draft Reports for Comment.--Section 718(a) of title 31, United States Code, is amended by striking ``Federal Reserve Board,'' and inserting ``Board of Governors of the Federal Reserve System, the Federal Open Market Committee, the Federal Advisory Council,''.
Thursday, May 7, 2009
The financial system exists to serve the real economy by allocating capital, providing information for other real-sector decisions regarding risk and the timing of saving and dis-saving, providing liquidity for current transactions, and facilitating some government interventions in the economy. But it doesn’t always work right. When it fails, nothing great is lost by its failure per se – but much may be lost as a result of its influence on the real economy. When the financial system functions well, its signals that certain firms should be liquidated are invaluable. But if it starts sending those signals wildly, the cost of liquidating valuable real capital can be devastating. Build a firewall that shuts down those signals when something goes badly wrong.
2.Limit aggregate leverage.
Debts don’t add neatly. Some cancel out; others are unrelated. In a complete, autarkic economy the total debt is always exactly zero: every debt is both a liability owed by someone and an equal-and-opposite asset owed to someone. But they don’t look that way on paper: the debtor must acknowledge the full amount of debt, whereas the debt-holder must acknowledge the risk of default. So on paper the total assets are less than the total liabilities. For any set of financial obligations – even if they’re not explicitly in the form of debt – this difference is what I call aggregate leverage. Aggregate leverage is one way of viewing a key difference between debt and equity: the obligation to shareholders is always exactly whatever is left on the liability side of the balance sheet and therefore changes freely in rough accord with the value of the stock to the shareholders, whereas bonds contribute to aggregate leverage. Entire segments of the economy can be financially insolvent despite possessing real assets in excess of their external financial obligations, if their aggregate leverage exceeds the difference. Even short of actual financial insolvency, excessive aggregate leverage can cause financial distress by limiting the ability to raise capital. Obviously, this is to be avoided. Regulation must ensure that it is.
3.Limit pricing feedback.
In an ideal market, prices are determined by supply and demand: in the event of a shortage or glut, the actual price is shifted back toward the price at which the market clears. In many real markets, however, this mechanism does not function adequately: the market value of the asset is whatever speculators say it is. Rather than linking producer and consumer, the market merely finds a consensus between speculators who buy at any given moment and those who sell. Such markets are subject to free-rider effects, where some participants buy or sell based not on their evaluation of the fundamental value of the asset but on what price others have been buying and selling for. Such an echo chamber amplifies noise as well as signal. If an increase (or decrease) in the price of one transaction leads to an equal total increase (or decrease) in the prices of subsequent transactions, any change will lead to a bubble or crash. Even at lower levels of feedback gain, there will be excessive volatility and persistent mis-pricing. Regulators must evaluate how financial markets function, and intervene as needed to limit pricing feedback.
4.Impose accounting requirements.
Accounting must produce comprehensible book values. These values will never reflect economic reality perfectly, and there’s an inevitable trade-off between the sophistication with which accounting mirrors economic reality and the ease with which it can be understood. However, there are also incentives to obfuscate. Voluntary accounting standards have failed to keep asset valuation comprehensible. Regulators must intervene as necessary to ensure that accounting is transparent.
5.Systematically recognize limitations of markets.
Academic economists have described numerous ways in which markets can deviate from the textbook ideal, and theorized at length about the effects of such imperfections. They also have theorized about what cannot be expected even from perfect markets. Regulators must systematically take such understanding into account when evaluating what regulation is required.
6.Regulate for systemic risk both ways.
There has been some debate as to whether it is necessary to have a new regulatory entity specifically charged with limiting systemic risk, or whether to require various regulators to assess the contribution to systemic risk from factors within the scope of their authority. The prudent course is to do both, and to include evaluation of other agencies among the responsibilities of the systemic-risk regulator.
7.Separate firms where warranted.
One of the factors implicated in the current crisis is the Gramm-Leach-Bliley Act, which repealed the mandatory separation between banks and other financial institutions provided by the Glass-Steagall Act. Such separation should be reinstated, but not necessarily in exactly the original form. Factors to consider include transparency and the incentives the combined firm and each of its components would face.
8.Provide guarantees as needed to break any contagious risk cycle.
Trouble at one firm can cause trouble at others. This can happen by outright failure, default during bankruptcy reorganization, financial leverage as described above, or effects in the real economy such as when a supplier who loses one customer no longer has the economies of scale to continue providing a product to another customer at an acceptable price. Regulators must be alert to all such possibilities and break the cycle before it becomes catastrophic, usually by providing some firms with guarantees against the losses incurred when another firm encounters trouble.
9.No implicit guarantees.
Part of the reason AIG caused as much trouble as it did is that firms counted on the government to bail it or them out if it couldn’t fulfill its obligations – and thereby created a situation where the government faced intense pressure to do so. The government must be clear about what guarantees it is providing, and what guarantees it is not. It must also ensure that it is able to follow through on its non-guarantees without catastrophic effects.
10.No promises you can’t keep.
Most of the reason AIG caused so much trouble is that it made commitments it had no means to fulfill. Firms must be forbidden from doing so.
11.No gaps in regulation.
There must be no significant players that go unregulated simply because they don’t fit any regulatory category. That may mean that some activities are entirely forbidden because they were not anticipated when regulation was devised. It may mean that regulatory schemes include catch-all categories for anything that doesn’t fit any other category. It may result in some loss of innovation, but the value of innovation is finite.
12.Policies must be predictable.
Regulatory systems will have to continue to adapt to changing circumstances and understanding. But such adaptation must occur at a limited pace so that firms will have a predictable regulatory environment in which to do business, and so that the system will not be excessively vulnerable to a wave of deregulation.
13.Too big to fail is too big to exist.
We must never be faced with another choice between a failure like that of Bear Stearns and a bailout like that of AIG. The first line of defense against this possibility should be the simplest: break up any firm that is too big to fail.
14.Risk must not just flow uphill.
Every effort at risk management has some assumptions. Those create an “unless” clause: the risk is contained unless something in the assumptions fails to hold up. When risk management is apparently perfect, nothing can go wrong – unless everything goes wrong. The classic example is the system of alliances before World War I, which seemed to have achieved “peace in our time” but in fact led to “the war to end all wars.”
15.Contagion must have a price.
Banks that receive FDIC guarantees of their deposits pay into the FDIC for the privilege of having those guarantees. The same principle must be applied in any guarantee provided under principle #8 above. The firms that receive the benefit should be required to pay the cost, to avoid distorting the incentives they face.
16.Ratings agencies must be formally part of the system.
Currently, ratings agencies can claim that they’re no different than a newspaper, exercising their rights under the First Amendment. That is not an acceptable basis for the role they play. Accounting standards should require ratings from an agency that is explicitly providing a service for a fee or otherwise taking a stake in the transaction, so that its legal position is different from that of a newspaper.
17.There has to be a reality check.
Interest rates and other rates of return theoretically reflect economic quantities such as the marginal product of capital and consumers’ marginal rate of substitution between current and future goods. In a goods or factors market, the reality check is provided by market clearing: if there’s a glut or a shortage, something is out of balance. But in financial markets when one side of the transaction is denominated in goods that don’t exist yet, this automatic reality check is not available. Regulators must devise some alternative way of providing one.
18.Profit for Wall Street is cost to Main Street.
When auto workers are making high wages, that’s widely understood to be good and bad: good because the workers get to have a high standard of living, and bad because means higher prices for consumers and lower returns for shareholders and bondholders. When the financial industry builds an Emerald City of skyscrapers, private jets, and luxurious offices, it isn’t as universally recognized that this means lower wages for workers and lower returns for Main Street investors. But it does. Maximizing “economic profit” isn’t the same as maximizing “accounting profit.”
19.If something sounds too good to be true, it probably is.
AIG was running what looked like an automatic sure-thing money-making machine. No such thing exists. Such impossible successes should be a red flag to regulators – not an automatic cause for action, because they can be mistaken about what’s too good to be true. But more often than not, further investigation will reveal that it was a wake-up call. When regulators find such a case, they must respond to it systematically, not just by addressing the particular case that drew their attention to it.
Wednesday, May 6, 2009
A machine breaking down
In a machine parts can break. With some parts, when they break the machine functions almost as it did before; other parts are critical to the functioning of the whole machine. Some machines, like the systems that provide life support for astronauts, have multiple redundancy in practically every component. Other machines are designed for reliability by having relatively few components, by having each component be highly reliable, or by monitoring and preventive maintenance of every critical component. In the financial system, a part that breaks and causes the whole system to malfunction can be a single too-big-to-fail company, but it can also be a cluster of interconnected firms, or a whole sector.
If each person who catches a disease infects, on average, at least one other person, then the disease will become an epidemic that grows exponentially until something changes so that the transmission rate falls below one again. Likewise, if each firm that goes bankrupt causes, on average, at least one other firm to go bankrupt, then there’s an epidemic of bankruptcy. Or if each dollar of loss in the value of one firm’s bonds causes a loss of a dollar in the total value of all the bonds of other firms that hold the first firm’s bonds, then there’s an epidemic loss of confidence in the ability of leveraged companies to meet their obligations.
The system of alliances before World War I
The system was perfect. Nothing could possibly go wrong – unless everything went wrong, which of course it did.
The most familiar example is the Tacoma Narrows bridge collapse in 1940. If some aspect of the financial system has an equilibrium and a restoring mechanism that can overshoot, it may be subject to positive feedback that sends it farther from equilibrium until it collapses. I’m not aware of any dynamic in the financial system that works this way, but it is a possible way of looking at aspects of the crisis that we don’t understand.
Perhaps the metaphor of the credit flow “freezing” has some insight to offer. A complex system has many parameters, but typically some are not very significant. For example, in a gas it doesn’t make much difference how big the molecules are or how they can fit together, because there’s lots of room and the kinetic energy of the molecules is high enough that they don’t stick together. When values of some parameters change – temperature and pressure in the example – the parameters that were unimportant suddenly determine a new type of behavior.
A cliff in the fog
Maybe there isn’t always anything much to know about how we get to the point of systemic troubles: maybe it’s just that no one is steering, or the people steering can’t see where we’re going.
A twitchy racehorse
The people who brought us the financial crisis were supposed to be geniuses who were making everything work better. Well, maybe it’s true. Maybe achieving higher performance always involves pushing things to their limits, and always has drawbacks. Another example of greater responsiveness coming at a cost is in biochemistry. When researchers first discovered that we have different enzymes for the same reaction in opposite directions, they expected that we would never have both active at once. Such a “futile cycle” consumes energy while accomplishing nothing. But we do. It turns out that a metabolic pathway with a “futile cycle” can switch much more quickly from one direction to the other than one without. Demanding perfect switching ability, though, would mean that the cycle would have to consume an unlimited amount of energy. So we only have enough “futile cycle” activity to switch reasonably well. Our metabolism makes a compromise between plodding like a plow-horse and being ready to spring out of the gate like a racehorse. Our financial system may have to do likewise.
A solid object may be kept aloft by a difference in pressure between its upper and lower surfaces, with the total upward pressure being greater than the total downward pressure by an amount sufficient to compensate for the weight of the object. Practically, this means that either it's lighter than air and the pressure difference is hydrostatic, or it's moving and the pressure difference is hydrodynamic. However, there is a third possibility: the pressure difference is hydrostatic, and the air can't get around the object at a significant rate.
My invention is simply several square kilometers of plastic sheet, some means of keeping it spread out and level, and a few air pumps. Air is pumped through as needed to keep up with the flow of air around the edges. The simplest means of keeping it spread out is probably rotation. Alternatively, the air being pumped through could be released in angled jets to maintain conformation, or air could be pumped through at controlled locations so that the pressure difference is greatest in the middle and the rest of the sheet hangs down slightly under tension. That last option would presumably require especially precise control.
How did they get the car up the hill with just their muscle power, no additional people or equipment?
But not all rights are property rights. If something is merely secured to you for a limited time, you don't own it. Lease, maybe. Own, no.
It follows that copyright infringement is not stealing.
Furthermore, under the Constitution, we do not balance the interests (let alone the supposed inherent rights) of the copyright holder against those of the public. The power Congress has is to promote progress, i.e. to serve the interest of the public. The interests to be balanced are the public's interest in copying freely and the public's interest in having more to read, see, hear, and copy. The latter is served, in a society where few have the leisure to pursue artistic activity full-time, by enabling people to make a living at artistic activity.
There's one other argument for copyright as property. It says that artists and thinkers inherently own any art or idea that they create, just because they created it, regardless of any government's pronouncements, and regardless of differences between ideas and tangible property.
But is creationism a good model for artistic activity? Is this how it really works: "In the beginning the world was without form and void, and darkness was on the face of the waters. Artist said, 'Let there be art.' And there was art."? Or is it more like an eternally-evolving noosphere in which timeless themes are repeated with each generation's particular variation?
Suppose there are two groups of people, and in each group a hundred people make up a hundred stories. In one group, each person is put in solitary confinement until they've written one story. The stories are sold to immortal corporations, and no story may be reproduced in whole or in part except for the financial benefit of the corporation that owns it, until seventy years after the death of the corporation (which never happens, of course). In the other group, people tell each other stories, then re-tell the stories, embellish them to be more pleasing, modify them to illustrate a point, simplify them to reveal their essence, extend them to develop a character, and so on. None of the people own any ideas: when one person has an idea, that enhances rather than restricts other people's ability to have related ideas. No one gets sued for plagiarizing themselves by telling a story too similar to one they told and sold, because ideas are not sold. In a hundred generations, which group will have better stories?
If the intellectual-property creationist view were correct, the first group would produce better stories. It just ain't so. The public domain is an artist's greatest resource. Allowing works to enter the public domain benefits not only the public as "consumers" of art, but artists as well.
Everyone has a natural right to sing, paint, write, think, etc. as they please, regardless of any similarity between their songs, words, thoughts, and so on and those that have gone before. Artistic activity is the opposite of alienated labor, not just one more kind of it. "Intellectual property" has it exactly backward.
This posting is hereby placed in the public domain. You may copy it freely.