Our view:
Treasury secretary Mr Geithner has once again served old wine in a new bottle. His proposals to lay out new rules for electronic trading of derivatives are old hat.
Not only are they strikingly similar to the proposal laid out by a small group of Wall Street Banks but also a replica of what Mr. Geithner himself along with the Federal Reserve had set out to do five years ago. A task they never executed with conviction and clarity of a diligent and alert regulator. A task half done, one of the possible reasons of the ballooning and subsequent crash of the world’s financial markets. Fortunately a large part of the task is now complete. As per the Depository Trust Clearing Corporation DTCC thanks to Deriv / SERV's automated matching and confirmation platform, nearly 90% of these Credit Default Swap CDS transactions are already being confirmed by T+1. This process of identification & tracking of Over The Counter derivatives and other securities has to be continuously monitored, refined, upgraded and rechecked for effectiveness as volumes and complexities increase. However to call such refinements and upgradations as new regulatory measures would be like terming a repaired or overhauled engine as new one.
The electronic monitoring and recording of derivative transactions started in 2002 and were supposed to be completed by 2006. That it was not monitored is a pity.
One of the more important causes of the housing bubble was a massive credit expansion, without proper documentation and control. An overly accommodative U.S.monetary policy during the period 2000 to 2006 encouraged the U.S.financial institutions to expand credit aggressively by reducing their short-term funding costs. These federal policies had the unintended consequence of encouraging financially marginal households that would never have qualified for traditional fixed-rate fully amortizing residential mortgage loans to take out riskier alternatives . These included the adjustable-rate sub prime residential mortgage loans with interest-only periods or negative amortization features which permitted a even weak borrower to buy homes . Essentially, both these borrowers and their creditors were relying on rising housing prices rather than the borrower’s income to repay these loans. As house prices zoomed largely due to( Standard & Poor's Home Price Index shot up from 84.8 in March 98 to 189.94 in March 06 ) the Banks relaxed the norms of borrowing further, and the demand of CDS Credit Default Swap Derivates rose many fold. So high was the demand that by the year 2002-03 the issuing Banks struggled to finish with the pending Back office paperwork to securitize these mortgages. Curiously the demand for FHA insured mortgages fell sharply during the 2000-2006 period as the demand for subprime mortgages shot up. With a large part of such transactions not electronically recorded, it is possible that there was a widespread demand manipulation which raised the prices and not real intrinsic demand.
The bull run during the 2002-2005 period witnessed a prolonged period during which the big derivative traders at the Wall street were swamped with demand and began issuing the mortgages without even having time to do the background paperwork for the securitization. Such was the rush for profits, that these CDS “credit default swap” derivatives during that period, were issued by the Wall Street biggies even before closely assessing the actual positions they held. The biggest among the traders were AIG, JP Morgan, Bank of America, Citi Group and Goldman Sachs, who amongst themselves controlled over three quarter of the market in the U.S , estimated to be well over $ 100 Trillion. When things got out of control, at NYSE, Tim Geithner, then the boss of Federal Reserve at NY belatedly pressed the top 15 financial firms who were issuing the derivatives to build an electronic network for recording of these instruments which was completed only by the third quarter of 2006. By then the damage was done. The market values had spiralled out of control and the price of both the securities as well as real estate surged beyond expectations.
By then, some financial institutions were already reporting problems about the subprime mortgages underlying these high priced securities. AIG's Financial Products unit, one of the largest issuers of credit-default swaps, stopped offering that insurance, and few others followed suit. Thus instead of becoming a risk distribution & risk management vehicle the CDS “credit default swap” securities became potential risks themselves triggering initial speculation and collapse of the markets thereafter. However unlike in the pre-2000 period, these CDS mortgage dealings should have been electronically recorded and traded, if the electroinic recording under Mr. Geithner's supervision been done diligently. So the reason of the CDS crash was not due to the lack of its electronic recording or regulatory mechanism, but the lack of implementation of already built in trading regulations
Nor will better hardware or massive data crunching and subsequent data mining solve the problem the problem, as Mr Geithner would like us to believe. The Bank of International Settlements has estimated that theoritical outstanding value of over the counter derivatives as of Jume 2008 was $ 684 Trillion. That is a lot more than previously estimated, one of the possible reasons that the Treasury & the Fed are playing ball with the Banks saddled with the toxic assets, and destroying their own credibility in turn.
It is no longer the technicalities and the numbers that really matter now that the collapse has happened. It is now the systems and the integrity and interpretation of code of fair accounting practice that has become more important.
What is really crucial is once the stock of the CDS derivatives and the transactions are completely recorded they must be untangled and revalued at the market price instead of being assessed at book value. That will no doubt downsize the highly inflated derivatives market and cause perhaps huge losses for the toxic Banks. However only once the are revalued and if necessary some may have to be written off over a 5 year period, to reduce balance sheet and share price damage. However this will help the ghost of toxic assets go away and the U.S. and global economies can come back to trusting each other and the integrity of the financial regulations. Else it is a only a matter of time that the international community drifts apart over the practices of regulatory agencies and the interpretation of U.S. Banking laws despite Mr Geithner's new rules.
In this blog from “ecology to economy” we deal with discussion of sustainable practices which we must adopt for the various aspects of economy as well as climate change. We are focusing in this issue on the proposed regulations in the derivatives market and the real implications it will have on the international economy.
We could be wrong. Tell us if we are & why? We encourage diverse opinion even if it is from commercially interested groups opposed to our thinking
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