A Sensible Approach

We admit it. We like headlines like this one − It’s Time for Sensible Regulation of Derivatives – which we first came across on The Exchange, a Yahoo! Finance blog.

But as it’s a blog (like media.comment), we weren’t too excited – until we saw that one of the authors was Martin Neil Baily, former chairman of the US Council of Economic Advisors. Dr. Baily (who served in the Clinton Administration) and his co-authors (who served in the Obama Administration) support derivatives activities:

“The bulk of derivatives are interest rate swaps, credit default swaps on corporate bonds and municipal and state bonds, commodity price derivatives, and currency swaps. These markets did not break down in the crisis and did not contribute to it.”

The authors also support prudent derivatives regulation, and “want to get that regulation right.” They are concerned, though, about some aspects of regulatory reform.

“It is worth asking if the myriad of rules put into place in Dodd-Frank to regulate derivatives can work together effectively and coherently. Congress, and the Financial Stability Oversight Council, should ensure that the different regulatory bodies work together to craft consistent rules of the game. Tackle the problems that emerged in the derivatives market and improve the economy’s stability, while still reaping the economic benefits derivatives can and do provide.”

It stands to reason: to develop effective derivatives regulation, we need to accurately understand the problems we are trying to solve. What are those problems? As Dr. Baily noted last month in a Brookings Institution conference on the purposes, structure and regulation of the financial industry:

“I think derivatives maybe have been…overstated a bit in their influence on the crisis. Like many historical crises…the one we’ve been going through I think was fundamentally caused because financial institutions bought and held bad assets…”

He went on to note:

“…I don’t think derivatives are the main story and I think all derivatives should not necessarily be viewed as toxic as Buffett said…”

One of the major issues related to derivatives in the financial crisis, he said, was “We didn’t know enough about the derivatives that were out there, who was holding them, what the implications would be…there was a real lack of information.” This concern helped give rise to the establishment of trade repositories to which market participants report their transactions, providing regulators more and better and deeper transparency on exposures and activities than ever before. (The need for regulatory transparency is why we oppose fragmentation of trade reporting and repositories, as outlined in our recent letter.)

The other major issue noted by Dr. Baily was AIG’s credit default swaps. As we have written elsewhere, the AIG situation reflected a failure to adequately measure and manage liquidity and collateral requirements. Had a robust variation margin framework been in place, AIG’s bail-out likely would have been averted.

Sensible indeed.

Initial Thoughts on Initial Margin

A recent speech by the Federal Reserve Board’s Vice Chairman appeared to get the New Year off to an inauspicious start for OTC derivatives markets. Initial reports of the speech indicated that it called for tougher regulation and treatment of derivatives, including a requirement for initial margin.

Bah, humbug.

But then we actually read the transcript, and felt a little better. There are some key aspects to the speech that we agree with.

First, there’s recognition about the benefits of a robust variation margin (VM) framework and its role in achieving an important public policy goal:

“The [VM requirement] codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily. However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again [emphasis ours], since current exposures will not be allowed to build over time to unmanageable levels.”

Second, there’s acknowledgement of the impact that initial margin (IM) requirements will have on liquidity and on the cost and availability of OTC derivatives to end-users: “higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk.”

Another key point: the speech notes that “requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risk …” But that’s because the risk management practices of CCPs are not well-suited to manage such risks – and not because the risk of such instruments is unmanageable (for more on this, see our December letter to BCBS-IOSCO on Margin Requirements For Non-Centrally-Cleared Derivatives).

There are, to be sure, some points that we disagree with. And there are some that we really disagree with.

We don’t, for example, believe that IM will reduce systemic risk. If done improperly, it could actually be highly pro-cyclical and increase systemic risk.

And we also don’t see how margin requirements can “diminish the incentive to tinker with contract language as a way to evade clearing requirements.” This notion ‒ that IM is needed to enforce or incentivize clearing ‒ has taken hold in some circles to justify the imposition of IM, but we don’t think it lines up with the facts. Clearing has happened, is happening and will continue to happen because it is a cost-effective means of managing risk through standardized products.

As we stated in the letter to BCBS-IOSCO mentioned earlier: “If a transaction is not clearable, then no amount of IM can cause it to be cleared. If it is clearable, then legal mandates – and not punitive IM – should drive clearing. If a high level of IM is the tool used to try to incentivize clearing, not only would such a strategy fail, but there would be…. potential adverse ramifications.”

2013 looks like a year in which we will be talking a lot about margin requirements. We’re not sure if this will keep us merry and bright over the next 12 months, but it should keep us busy.

Back To The Future

Everyone in OTC derivatives is so busy preparing for the future that we wonder if it’s even worth going back in the past to reexamine some popular assumptions about the financial crisis.

But, in light of a couple of recent developments, we just can’t resist.

First off, witness the exchange that took place recently on CNBC’s Mad Money between host Jim Cramer and his guest, AIG CEO Robert Benmosche. They are talking about the events surrounding AIG’s financial difficulties in September 2008 (starts 8:27 into clip).

Benmosche: …the issue was not capital. The issue was cash. They didn’t have cash.

Cramer: Right, did they have the collateral for the…

Benmosche: They actually had the collateral, but the question was they had no window to go to, because they weren’t a bank until afterwards. Had the same been given to AIG that was given to other companies after AIG got the bailout—as you know, some of the investment houses were given access to the Fed window; other large institutional companies were given access to the Fed window. Had AIG had the same access, I believe that would have solved the liquidity crisis they had.

Cramer: So it wasn’t that bad off, then. It was just a question of the moment in time.

Benmosche: It was cash to meet collateral calls, because, in the end, the financial products that were put on the books, that were bought by the Fed—you saw the profits already—we believe almost all of that will accrete back to what it was supposed to be.

Cramer: That’s incredible.

Benmosche: It was a question of the markets had tanked, the way the accounting was done—which was changed, okay? But the accounting was very aggressive at that point in time, and so it required too much cash to be put up on things that, ultimately, would have worked.

(click for full CNBC transcript)

We prefer to leave the ultimate takeaways from this exchange (and there are several) to our readers. But there’s one worth pointing out. AIG’s actual final cash losses on the credit protection it wrote were not why it needed a bailout. Realized losses would not have caused its collapse.

It was, instead, the cash that had to be posted as collateral for those contracts that caused the company’s distress. This is a point echoed by a new paper from Harvard Professor Hal Scott and the staff of the Committee on Capital Markets Regulation:

To be sure, after AIG’s long-term debt was downgraded by each of the three rating agencies… AIG did not have enough liquidity to meet further collateral demands. Indeed, the downgrades coupled with subsequent market movements caused AIG’s collateral posting obligations to soar to more than $32 billion over the following fifteen days, compared to only about $9 billion of cash entering the week.

A turn not marked on the roadmap

Why is all of this worth rehashing four years after the fact? Because today, the policy debate regarding OTC derivatives is taking a turn that was not on the G20’s original roadmap. That map, as articulated in 2009, called for more clearing of standard, liquid swaps; appropriate capital standards across firms; and increased regulatory transparency. ISDA fully supports ‒ and has actively driven towards ‒ these G20 goals and regulatory efforts to reduce systemic risk.

So what’s the dangerous turn in the road? It’s about efforts to fashion capital and margin requirements for OTC derivatives that can’t be cleared. There are a number of different types of these instruments, used mainly by a variety of end-users in the ordinary course of their businesses, and they total 20% or so of the overall OTC market.

Some would like to see all OTC swaps centrally cleared. Clearinghouses, however, are the new too-big-to-fail institutions. They need to be protected. They must only clear liquid, standardized products. To jam them with less liquid, less standardized products could have potentially disastrous consequences. They must be kept pristine.

Uncleared derivatives are not necesarily any more risky than cleared swaps, it is just that they do not meet the (appropriately) very high bar at the clearinghouses. They do, however, have enormous social value. Examples include inflation swaps, widely used by pension funds globally and cross currency swaps, which are vital to the funding operations of corporations and governments.

It is also worth noting that the types of unclearable OTC derivatives used in the real economy generally have nothing to do with the type of CDS that AIG wrote. (Those were also unclearable and as a result have cast a shadow on the whole category of unclearable swaps.) But the desire to avoid AIG-type situations is potentially leading to a margin framework that could quite possibly end transactions in this important sector, essentially throwing the baby out with the bathwater, and in doing so perhaps perversely increasing risk in the system.

We, like regulators, want to build a framework that ensures AIG can’t happen again. And we believe that experience provides that the best way to do this for uncleared swaps is through a robust variation margin (VM) regime – one in which transactions are valued and collateral exchanged on a daily basis. Frequent exchanges of collateral between counterparties means that large credit exposures that could become destabilizing in periods of market stress can’t build up. Had this practice been followed four years ago, we would not be talking about the AIG situation today. AIG did not, as a matter of course, post daily VM to settle liabilities with its counterparties.

Another example from 2008 draws a stark contrast. Unlike AIG, Lehman Brothers did have robust VM arrangements with its counterparties. Those VM arrangements ensured that the Lehman default did not cause any systemic contagion.

However, while VM is clearly an effective part of the regulatory framework for swaps, policymakers are considering an additional step. They are proposing to impose a different kind of margin – initial margin. This can be thought of as a buffer, a safety cushion of extra collateral over and above any monies owed between parties. The goal, again, is to reduce the chances of systemic risk from a major default.

The Initial Margin paradox

Initial margin, or IM, does help reduce systemic contagion, but it does so at the cost of making market participants more likely to default, since the posting of initial margin consumes valuable liquidity resources at banks, and importantly, creates a future contingent liquidity draw of potentially terminal proportions. This is because IM requirements increase in response to increased market volatility. This procyclical funding draw will happen in the heart of a crisis, at the worst possible time for market participants.

Regulators could undercut the very goal of systemic resiliency that we are all trying to achieve. Our recent presentation makes this clear.

Professor Scott’s paper also makes it clear that AIG’s collapse did not pose systemic threats (questioning in another way the need for IM):

…it is widely believed that…AIG was saved because of the interconnectedness of its derivative positions with other important financial institutions. While it is relatively clear that derivatives helped to bring down AIG, there is no substantial evidence that its failure would have put its counterparties at risk of insolvency. Direct losses from in-the-money CDS positions held by counterparties would have been small relative to their capital.

In addition to these concerns, The IM proposals also can have significant adverse economic and financial consequences. As noted above, they could possibly put an end to the uncleared swaps market. Some commentators might welcome this, but such a position is quite frankly, absurd. Unclearable swaps are critical to the proper functioning of vital sectors of the economy, such as the US housing market and financing of corporations. They are an essential component of the lifeblood of the broader global economy.

We need to get this part of financial regulatory reform right. And to do so, we need to look back so we can move forward.

It’s what you didn’t say….

A number of stories last week – like this one – chronicled the fact that regulations stemming from Dodd-Frank on the OTC derivatives markets have begun to take effect.

These stories quite frankly come as a bit of surprise.  But it’s not because of what they say.  It’s because of what they don’t say.

Let us explain.

Over the past two years we have seen and heard countless times statements along these lines:

“Representative Barney Frank, who was the co-author of the Dodd-Frank Act, says the law will help prevent a repeat of the financial crisis.”  (New York Times)

“The Dodd-Frank financial reform overhaul last year aimed to curb the excessive Wall Street risk-taking that nearly leveled the financial system.”  (Reuters)

These statements reflect that financial regulatory reform globally, and Dodd-Frank in the US, was intended to be fundamentally about reducing systemic risk: making the financial system safer and more robust, ensuring financial institutions took risk and capitalized against it appropriately and ending bailouts of too-big-to fail institutions.

In the OTC derivatives markets, this mostly meant increasing the use of central clearing, ensuring appropriate margins for uncleared swaps and improving regulatory transparency.

Significant progress has been made in all of these areas.  More than half of the interest rates swaps market is now cleared. Regulators have transparency into market-wide and individual firm risk exposures. The vast majority of OTC derivatives positions are collateralized.

This has all been done in advance of the imposition of the new rules. As a result, the system is much safer and stronger than two or three years ago. Further progress is on the way, and it will be safer and stronger still.

Most of this remains unsaid. Much of the focus last week was instead on non-systemic issues that are not central to the fundamental goals of regulatory reform.

Post hoc, ergo propter hoc

After this, therefore because of this.  

Students of Latin (and devotees of the The West Wing TV show) know that the phrase above describes a common logical fallacy. One thing does not (and can not be said to) cause another simply because it came first.

The current debate over rising commodity prices brings this thought to mind.

As several recent articles have noted (including these from The Independent and the Financial Times), there has in recent years been an increased flow of investment funds into commodities. Commodity prices have experienced volatility and price changes during this time.

This has raised concerns that the “financialization” of and increased financial speculation in these markets are adversely impacting them. One thing (increased investment) leads to the other (higher prices), at least in the minds of some.

Given its importance, there have in recent years been a number of research studies conducted by leading academics and government institutions into this issue. What does the research show?

As Professor Craig Pirrong of The University of Houston has written, “As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.” In addition, a US CFTC Commissioner — Michael Dunn — stated in 2011, “To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive speculation.”

In fact, there is today abundant evidence that supports the view that speculation makes little, if any, difference to food prices and price volatility:

Criticism of “speculation” and “financialization” might be timely and trendy, but it’s important to base policy decisions on the facts.  As ISDA has written:

“Although speculation is often blamed for causing problems in markets, the economic evidence shows that it is in fact a necessary activity that makes markets more liquid and efficient, which in turn benefits hedgers, investors, and other market participants.  Speculation increases market liquidity by reducing bid-offer spreads, by making it possible to transact more quickly at a given size, and by making markets more resilient.  Speculators make markets more efficient by helping move prices closer to fundamental values: short sellers, for example, provide discipline against overpricing while speculative buyers counteract unjustified drops in price.  Without speculation, markets would be less complete in that there would be fewer opportunities for other market participants, especially hedgers, wishing to manage the risks they encounter in their financial activities.”

The potential adverse impact is echoed in the academic literature. An EDHEC-Risk Institute paper notes that “proposals to restrict speculation fall somewhere in the continuum of being a placebo to actually being harmful to the goals to which they aspire.”

In addition, the Irwin-Sanders paper states:  “the policy implication of the available evidence on the market impact of commodity index funds is straightforward: current regulatory proposals to limit speculation — especially on the part of index funds — are not justified and likely will do more harm than good…. The net result is that moves to tighten regulations on index funds are likely to make commodity futures markets less efficient mechanisms for transferring risk from parties who don’t want to bear it to those that do, creating added costs that ultimately are passed back to producers in the form of lower prices and to consumers as higher prices.”

All of this brings to mind another Latin phrase that’s worth keeping in mind the next time someone tries to sell you a story about the financialization of commodities markets:
Caveat emptor.

ET Phone Home

ET Phone Home…There have been many jokes, quips and witticisms about the unfortunately named extraterritoriality (ET) issues related to OTC derivatives rules in the US.

Some have even been funny.

But not everyone is smiling about ET, as this story by Dow Jones/The Wall Street Journal points out:

“European Union and U.K. regulators urged the U.S. to delay new rules for swaps contracts and reconsider how they apply to foreign banks and transactions.  The complaints add to a chorus of concerns, including from Japanese, French and Swiss regulators, that the U.S. is overstepping its jurisdiction.”

What, exactly, is the beef?

According to a letter from the European Commission that’s quoted in the article, the US rules could “lead to duplication of laws and to potentially irreconcilable conflicts of laws for market operators.”

This is a theme we have sounded before.  It’s also one that policymakers from Asia are voicing.  Earlier this week, five regulators from three Asia-Pacific jurisdictions (Hong Kong, Singapore and Australia) jointly signed a letter to the CFTC voicing their concerns.  As their letter states:

“…we are concerned that some of the proposed requirements as they currently stand may have significant effects on financial markets and institutions outside of the US. We believe a failure to address these concerns could have unintended consequences, including increasing market fragmentation and, potentially, systemic risk in these markets, as well as unduly increasing the compliance burden on industry and regulators.”

Is there a solution in sight?

Perhaps.  As Hong Kong’s Secretary for Finance Services and The Treasury separately wrote to US policymakers:

“…we call for greater coordination internationally on implementation of OTC regulations, particularly those with cross-border implications.  We hope the CFTC, SEC and the US Treasury will defer the application of the US rules and regulations over non-US persons and work with the international community on a coordinated framework on regulatory cooperation in cross-border OTC transactions.  We also hope the US authorities would provide greater clarity to the Proposed Guidance and to recognize the OTC derivatives regulatory regimes of overseas jurisdictions on the basis of international standard.”

The lines are open.  Regulators are standing by.

Not So Fast, Let’s Stop and Think

Today’s New York Times contains an interesting story — “Strong and Fast Markets, But No Time to Think” — that reflects on the trading glitches that roiled equities markets on Wednesday.

The article discusses the evolution in securities trading over the past quarter century. It states that this change has largely been positive, but also points out potential pitfalls.

Chief among them: “…the improved markets also are more prone to disaster.” Why? Partly because “Market makers have been largely replaced by high-frequency traders who use computers that can react to orders in nanoseconds.”

As evidenced by yesterday’s problems, or those related to the “flash crash” in May 2010, no trading system is perfect.

There is an interesting parallel here to the OTC derivatives markets. Current policy proposals might significantly change their structure and the role that market makers play in them. These proposals could transform OTC derivatives from an institutional market with low trading volumes and large notional amounts per trade to a quasi-retail market with vastly higher trading volumes and small notional amounts per trade.

We’re not sure what purpose this would serve. Given the price competition and the extremely tight spreads in the most liquid part of the OTC derivatives markets, the impact on trading costs would appear to be minimal.

It is true that smaller end-users might benefit from lower costs, but any benefit here is likely to be more than offset by the higher costs that larger end-users might incur.

Simply stated, there is very little evidence to support the idea that the proposed changes in the structure of OTC derivatives trading would benefit market participants.

As a result, we do not think these market structure changes were the intent of the G-20 Communique issued in Pittsburgh in 2009 that formed the basis of the legislative proposals that have since advanced in key jurisdictions.

To the contrary, we believe that the overriding goal of post-crisis public policy initiatives is to build a stronger financial system and reduce systemic risk.

Efforts to increase central clearing of trades and to improve regulatory transparency do just that, which is why we and market participants are on board with and helping to drive progress in these areas.

Efforts to change how one market works should clearly be backed up by substantial evidence that those changes will bring improvement. For OTC derivatives, that evidence has been a slow train coming.

No Evidence? No Problem

“To the market’s credit, there is no evidence that the process has become corrupted by big banks.”

That’s what an article in The New York Times Dealbook says about how credit events are determined in the CDS market.

The comment, unfortunately, is buried deep within the article. It’s easy to miss.

Most of the 800-word piece focuses on how the credit event process has the potential to be flawed. Its basic premise is that the ISDA Determinations Committees (DC) and credit event process appear to operate in a cartel-like fashion.

We stress “potential” and “appear to” for two reasons. First, the article doesn’t actually allege any wrongdoing. As noted above, it acknowledges that there is no evidence to this effect. Rather, the article merely posits that because of the way it operates, there is the possibility that problems might occur.

We’re not sure exactly how the DC process is or can be cartel-like. There are effective mechanisms built into it to ensure it isn’t and can’t be. Most notably, each DC is composed of 10 sell-side and 5 buy-side firms, and an 80% supermajority vote of the 15 members is required to make a credit event determination. Neither the sell-side nor the buy-side alone can force a decision its way; a broad market consensus is necessary.

What other flaws does the article cite?

One has to do with the claims that the DC “operates as a quasi-Star Chamber.” It would be great if we could cast Michael Douglas or Hal Holbrook (the stars of the 1983 movie of that name) in the lead DC roles. But we’re not sure the DC process would qualify as a theme for a remake of the movie. Virtually every part of the process is public: the rules governing the DC; the composition of the DCs; the determination requests made by market participants; the aggregate DC votes; the individual votes of DC members; the auction process and prices; adjustment amounts paid by firms as part of the auctions, and so on.

Another potential problem cited by the article isn’t a problem at all: it’s a source of strength. It has to do with the fact that DCs can be asked to consider and vote on a credit event multiple times as the facts of a situation change.

For example, in the recent situation involving Greece, the ISDA EMEA DC was asked to determine whether a credit event had occurred prior to the execution of the bond exchange. It determined at that time that it had not. Shortly thereafter, the deal was officially executed and the DC was again queried. It then ruled that a credit event had occurred.

This is hardly an example of “details shifting.” It is, rather, a prime example about how specific facts about specific situations involving specific Reference Entities can and do change. Prior to the use of the collective actions clauses (CACs) by Greece, there was no credit event. Following their use, there was.

In other words, facts matter. That’s why it is hard to say that one DC decision is precedent-setting for another.

The article opines that the DCs make decisions without having to publish their reasoning. It fails to note that most decisions are unanimous or close to it, obviating the need for explanations given that the consensus is so widespread. It does, though, note that ISDA and the DCs are currently discussing enhanced disclosures.

The “biggest concern” cited by the article is about potential conflicts of interest. These concerns stem from the fact that DC member firms may have an economic interest in the cases they are asked to rule on.

Two important points need to be made here. The first is that the DC rules incorporate the idea that market expertise – as evidenced by trading volumes – is a good thing to have on the DCs. So it’s no surprise that the DCs will be asked to make determinations on Reference Entities in which they have exposures. The second point is that regulatory disclosures and regulatory transparency provide an important check on any potential conflicts. Regulators have the ability to see a DC member’s exposures and benchmark it against its DC voting. This ability is enhanced under Dodd-Frank, which requires firms to report their OTC derivatives trades to trade repositories. This important check on the integrity of the process is cavalierly dismissed in the article.

At the end of the day, the article says that although there’s no evidence of wrong-doing, “trusting it to remain that way doesn’t seem like a good plan.”

The truth is, the DC process has always been built on the concept of “trust, but verify.” It was built with structural safeguards – checks and balances — to protect its integrity. Those safeguards are working. That’s why “there’s no evidence” of any problems with the process.

That, at least, is something we can all agree on.

Tropical Storm

Sometimes a story comes along that is so emphatically off-base that it makes you just shake your head and wonder. And sometimes it makes you write a riposte.

A recent opinion piece in the American Banker is a prime example. The main thrust of the article is that the credit default swaps (CDS) market is troubled because it does not function like the equity or options market ‒ you can’t get a CDS quote “on a website like Yahoo or Google.”

Really?

It’s hard to believe this is a serious point of discussion. Of course these markets function differently. From June 7 to June 13, 2012, between 7 and 8 million trades on NASDAQ-listed issues were executed each day. On the NYSE Euronext, about 1.6 million trades in European equities have been executed on average per day over the course of 2012.

In the CDS market, by contrast, about 6,400 contracts are executed each day. Globally. On all reference entities. It would take 1,172 trading days for CDS trading volumes to equal one day’s worth of trading volume for NASDAQ-listed issues. It would take 250 trading days for CDS trading to equal one day’s worth of European equity trading on the NYSE Euronext.

Anyone who knows anything about the CDS market realizes that CDS volume is relatively small, and that trading in most reference entities is not very liquid. A brief look at the DTCC data, for example, reveals that in a recent week (of May 15), the number of reference entities that traded more than 20 CDS contracts per day was 27 out of more than 800. In other words, on the order of 97% of CDS reference entities traded less than 20 contracts per day during that week.

Despite this public data, the article posits that:

“That leads us to perhaps the most saddening question of those posed above: Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?

Yes. Perhaps the most egregious form of cooperation is the effort to preserve the impression that there is active trading in a large number of reference names when in fact there is not. I know this having reviewed trading volume reported by the DTCC for all CDS reference names, including U.S. banks, sovereign issuers, and regional and local governments.”

“Preserve the impression?” This is ludicrous. Market participants have been telling anyone who will listen about the dynamics of CDS trading volume.

What could possibly account for this gap in understanding? Particularly given that it comes from a well-respected firm (that is lucky enough to be based in Hawaii)?

Could it be that the signals of CDS trading are sometimes misinterpreted? Or that they conflict with the firm’s own default probability solutions? Witness this:

“Breathless reporters or rating agencies claim ‘Dell’s CDS widen 42%’ when, in fact, there were only 9.6 trades of any kind per day and 1.75 non-dealer trades in Dell during the week ended May 25, according to the DTCC.

Reporters need a story, and the CDS mud pit provides material. Rating agencies need a product that is not a rating, and the CDS mud pit provides one.”

We agree that the trading volume of the CDS market needs to be better understood. And we agree that CDS price signals need to be viewed with the proper perspective. CDS do not aim to predict the probability of default, but they do accurately depict the cost of hedging against default. That is their intended purpose…and it is widely known. Even in Honolulu.

Any Given Sunday….

Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?