A Financial 'Time Bomb'?

A Financial 'Time Bomb'?
By Robert J. Samuelson
Wednesday, March 12, 2003; Page A21

http://www.southcentre.org/info/southbulletin/bulletin49-50/bulletin49-50-10.htm#P718_140987

Since the 19th century, governments have tried to prevent financial panics, which led to
economic slumps and depressions. In 1873 Walter Bagehot, editor of the Economist, published his landmark book "Lombard Street: A Description of the Money Market," which advised the Bank of England about how to stop bank runs. When the Federal Reserve disregarded his advice in the 1930s, the Great Depression ensued. Congress later enacted deposit insurance as another
protection against panics. To the list of financial threats can now be added "derivatives" –
sophisticated securities that are used mostly by big investors (banks, insurance companies,
corporations).

Just last week, legendary investor Warren Buffett denounced derivatives as "financial weapons
of mass destruction" that could cause economic havoc. By contrast, Federal Reserve Chairman
Alan Greenspan says derivatives have improved economic stability. Who's right? This is an
important debate, because derivatives have exploded and are implicated in two recent financial
scandals -- Enron's bankruptcy and the near-bankruptcy in 1998 of Long-Term Capital
Management (LTCM), a private investment fund.

About derivatives' growth, there's no debate. From 1990 to 2002, their face value rose from
$2.9 trillion to $127.6 trillion, says Randall Dodd of the Derivatives Study Center, an advocacy
group. These figures, based on data from the Bank for International Settlements, can be
misleading. The amounts at risk are much smaller than the face value -- probably less than 10
percent. Still, the numbers are huge and reflect two realities: (1) Derivatives are one way to make a fast buck; and (2) they allow companies and others to hedge against unfavorable economic developments – changes in interest rates, for instance.

Derivatives are so named because they "derive" their value from the future price movements of
some commodity or financial asset: oil, wheat or stocks. Small swings in prices can mean huge
profits and losses, because investors have to commit only tiny amounts of cash compared with
the contracts' face value. Buffett's fears start with this explosive arithmetic. In an extreme case,
LTCM used about $5 billion of investment capital to control more than $1 trillion of derivatives,
according to Dodd.

But trading isn't just gambling by speculators. In economics texts, farmers provide the classic
illustration of the advantages of hedging. Suppose you raise wheat. When you plant in the spring, the price is $3 a bushel. You can make a profit at that. The trouble is that you sell in the fall, after the harvest, and if the price drops to $2.50, you can't cover your costs. To reduce that risk, you invest in wheat futures contracts. If wheat prices decline, you offset losses on your crop with profits from your futures contracts. Thus reassured, you plant in the spring.

Hedging has spread far beyond the farm. Four-fifths of derivatives now involve interest rates;
another 10 percent or so involve currency exchange rates. These provide protection for companies whose businesses involve lots of debt or foreign trade. One benefit Greenspan has
argued, has been the mortgage-refinancing boom. Investors in mortgage-backed securities face
the risk that, if interest rates fall, homeowners will refinance. Investors lose. To minimize that
risk, they can hedge against lower interest rates. If they couldn't, they might impose larger
prepayment penalties or charge higher interest rates.

Similarly, Greenspan has noted that despite $1 trillion in worldwide lending to telelecommunications companies from 1998 to 2001, the subsequent telecom bankruptcies have
not caused any major bank failures. One reason, he contends, is that banks spread their lending
risks to other investors (say, insurance companies) through "credit derivatives." Dispersing risk
has made the financial system sturdier, he argues.

Buffett doesn't deny derivatives' theoretical benefits. Indeed, he's not worried by standard futures contracts such as wheat (traded on exchanges, such as the Chicago Mercantile Exchange). What frightens him is the possibility that newer derivatives (traded "over the
counter'' -- between one customer and another) could trigger a panic. Financial markets require
trust. Without it, people won't deal with each other. Credit and confidence shrivel. To Buffett,
derivatives are "time bombs" that could shatter confidence in three ways. First, a few big banks
dominate the market.

Among U.S. banks, seven (led by JPMorgan Chase, Citibank and Bank of America) account for 96 percent of derivatives holdings. "The troubles of one could quickly infect the others," he writes. Second, weakness could feed on itself. A company whose credit rating is lowered -- for whatever reason -- typically has to put up more collateral against its derivatives contracts. A "corporate meltdown" and defaults could ensue because the company needs more cash just when cash is least available.

Third, complex accounting rules for derivatives can lead to overstatements of profits (this was true of Enron) and confusion. All the "long footnotes" on derivatives convince Buffett "that we don't understand how much risk" is involved. Although Buffett could be wrong, his record in spotting financial excesses -- in tech stocks and executive options -- commands respect.
What can be done? He doesn't say. One thing that can't be done is to outlaw "speculators"
(customers trading for profit) and allow only "hedgers" (customers trying to protect themselves).

The markets need speculators to counterbalance hedgers. But as Dodd suggests, some steps
might improve financial safety. Capital requirements could be imposed on all dealers (banks have them, but non-banks -- such as Enron -- typically don't). Reporting requirements could be
increased. Even Greenspan concedes "the remote possibility of a chain reaction, a cascading
sequence of defaults" that would impel the Fed, heeding Bagehot, to try to rescue the financial
system -- an outcome that no one should want.

© 2003 The Washington Post Company

Deregulation of Derivatives Would Be a Bad Mistake

DERIVATIVES STUDY CENTER
http://www.financialpolicy.org/dscabmistake1.htm
www.financialpolicy.org
1600 L Street, NW, Suite 1200Washington, D.C. 20036
rdodd@financialpolicy.org

THE AMERICAN BANKER - August 11, 2000
Viewpoints: Deregulation of Derivatives Would Be a Bad Mistake- by Randall Dodd

The derivatives deregulation bills that a few members of Congress are franticly rushing through the legislative process are seriously flawed.
This is a huge market - the Bank of International Settlements recently estimated it at $190 trillion worldwide - but there has been scant public debate about deregulating it.
Arguments for doing so have gone unchallenged.
Public debate is not only essential to democracy on principal, but also serves the practical purpose of ferreting out policy errors and omissions.
Two very similar bills would affect the regulation of derivatives markets.
In the Senate, S.2697, co-sponsored by Sen. Richard Lugar, R-Ind., and Sen. Phil Gramm, R-Tex., has been reported out of the Agriculture Committee and awaits action from the Banking Committee.
In the House, Rep. Thomas Ewing, R-Ill., has authored HR 454, and slightly modified forms of the bill have been reported out of three committees - Agriculture, Banking, and Commerce.
All these versions of the legislation would exclude over-the-counter derivatives from government regulation and radically reduce the level or surveillance and supervision on futures exchanges.
The proponents of deregulation build their case on three points:
a) Financial markets are so large that they are not susceptible to manipulation.
b) There is no price-discovery process in over-the-counter derivatives markets, so there is no public-interest concern.
c) The OTC derivatives markets are made up of sophisticated investors who do not need to be protected from fraud and the failure of others.

Let me point out the problems with these premises.

RISK OF MANIPULATION

The world's largest and most liquid market is the one for foreign exchange.
Yet the Quantum Fund hedge fund operated by George Soros is widely credited - or blamed - for moving the market to devalue the British pound in September 1992.
The market for U.S. Treasury securities, with its $600 billion in daily trading volume and another $1 trillion in repurchase agreement transactions, is the world's premier market in terms of efficiency and sophistication.
Yet this market has been the subject of manipulation several times in recent years:
a) The prestigious bond trading firm of Salomon Brothers was found to have cornered the bond market in 1992.
b) In 1996 the investment bank Fenchurch was found to have corned the 10-year note market in order to manipulate the futures market.
c) Last December the head of the Federal Reserve Bank of New York's bond trading desk warned about repeated incidents of manipulation in the markets for repurchase agreement on Treasury securities.

PUBLIC INTEREST

The prices and rates established in OTC derivatives markets are, in fact, regularly reported as the reference prices and rates for other markets throughout the economy.
Information about rates and spreads in the interest rate swaps market is critical to those for home mortgages and corporate bonds.
This leading role is all the more important in light of the possible demise of the U.S. Treasury securities market as federal government surpluses continue to shrink that market.
The forward and swap rates on foreign currency are regularly and widely reported, and they are critical to international trade and cross-border investments.
This is not an incidental part of the OTC derivatives markets.
Interest rate swaps, forward rate agreements, and foreign exchange forwards and swaps make up 77% of the volume in the OTC derivatives markets, according the Bank for International Settlements.
The role of these markets in establishing prices used throughout the economy has long been the basis for regulatory oversight.
As the Commodity Exchange Act states:"The prices involved in such transactions are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining the prices to the producer and the consumer of commodities, and the products and byproducts thereof, and to facilitate the movements thereof in interstate commerce."
These markets "are affected with a national public interest" making it "imperative" that the federal government take actions to detect and prevent market manipulation and fraud.

SOPHISTICATED INVESTORS

Defining "sophistication" as having substantial wealth is not a good enough measure.
Moreover, requiring that investors be sophisticated is in practice not enough to assure safety and soundness.
Imagine an investment firm with $5 billion in capital and management made up by the former head of the top bond trading firm on Wall Street and a couple of economists who received Nobel prizes for developing derivative pricing formulas.
This combination of capital, financial market experience, and intellectual brilliance is at the very highest standard for market sophistication.
Yet these attributes, plus $1 trillion in derivatives, were the state of Long Term Capital Management.
These sophisticates orchestrated such an enormous failure that they lost not only 90% of their investors' money but also disrupted market activity and threatened the solvency of many of the largest financial institutions.
Sophistication is clearly not enough to assure that derivatives market do not threaten the rest of the economy.
In light of these problems with the premises underlying the broad-reaching deregulation of derivatives, lawmakers should halt their frantic rush to cut them loose from regulatory oversight.
Instead they should pursue a deliberate course to determine the appropriate level of regulation.

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Welcome to STOP GOP!

Welcome to STOP GOP! This blog serves to remind voters that they have the power to boot the Republican Party out of politics because the GOP deserves to be reprimanded for their failures at both domestic and foreign policy since BushII was appointed President by the Supreme Court in 2000. The Republican Party have been a staunch advocate for deregulation - a proposition inspired by the Reagan Revolution that states that government is the problem instead of the solution. Instead of prosperity for all Americans as promised, deregulation has been a disaster. It has wreaked havock in the stock market causing losses to average investors, ruined our stature in the world, created billionaires on the backs of America's working families, and caused a conceivably insurmountable level of national debt.

Lately, the newspapers have been harping on polls that show that the race between Obama and McCain for the Presidency is a statistical tie. Please keep in mind that this election is about CHANGE. And both parties are aware that. Yet, Obama is the most qualified candidate to deliver change. McCain has been a fixture in Capital politics since the Reagan Revolution. He is a "maverick" icon of the past. He is simply incapable of bringing about desperately needed change in Washington, DC.

McCain's running mate, Sarah Palin, is worse. She thinks that experience at community and grassroots organizing does not qualify a candidate to achieve change. Ms. Palin is apparently ignorant at the fact that the tactics of today for electoral victory are based primarily on a vast and solid netroots and grassroots network that require the skills of effective community organizing. Worse, she belittles the vital experience that Obama has at community organizing. Although she presents a fresh look for the cameras, Palin might as well be considered yet another relic of the past.

Overall, it is the Obama campaign that has truly inspired voters to believe that change is clearly possible. Since the inception of the Obama for President campaign in 2007, a vast netroots network for GOTV and raising money has been growing on a daily basis. Thus, the rules for "change" from yesteryear based on insider networking no longer apply. Instead, the tactics which accomplish community and grassroots organizing will result in an electoral victory from the bottom up instead of the top down.

Let's unite and demonstrate the power of netroots and grassroots by booting the GOP from politics. It's time to bring to an end a failed domestic and foreign policy reared by the Republican Party. We must take action and STOP the GOP on election day, Tuesday, November 4, 2008 by voting for Obama for President and other candidates listed on the Democratic ballot.