Tag Archives: Philip Davis

On The Third Wednesday Of Christmas, My Wall Street Elite Gave To Me…

Louise Story in NYT:

On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.

The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.

Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.

In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.

The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.

Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

Derivatives shift risk from one party to another, and they offer many benefits, like enabling Mr. Singer to sell his fixed plans without having to bear all the risk that oil prices could suddenly rise. Derivatives are also big business on Wall Street. Banks collect many billions of dollars annually in undisclosed fees associated with these instruments — an amount that almost certainly would be lower if there were more competition and transparent prices.

Just how much derivatives trading costs ordinary Americans is uncertain. The size and reach of this market has grown rapidly over the past two decades. Pension funds today use derivatives to hedge investments. States and cities use them to try to hold down borrowing costs. Airlines use them to secure steady fuel prices. Food companies use them to lock in prices of commodities like wheat or beef.

Emily Lambert at Forbes:

Forget baseball, football, or any other sport. For the past two decades, the most interesting rivalry involving these cities has been in derivatives. It’s been the most important rivalry, too. Sports match-ups affect civic pride, but the derivatives battle affects the structure and stability of the financial system.

The rival teams are like the blue bloods versus the scrappy underdogs. The Wall Street club includes the country’s biggest dealers and needs little introduction. The Wall Streeters represent banks, institutions and exclusivity. They play the game of unregulated (or differently regulated, they argue) derivatives, to the tune of $600 trillion.

The Chicago team, based on and around La Salle Street, include the small traders and street fighters. They also have a club, and it too was private and pretty exclusive for years. It’s now the publicly-traded CME Group. But their club included its fair share of taxi drivers, policemen, train conductors, and other everyday folks. This team trades regulated derivatives, better known as futures and options. That market is huge but nowhere near as big as the unregulated (or differently regulated!) side.

These rivals have butted heads since the 1970s, when the Chicago club expanded beyond the world of agriculture and into financial products, New York’s domain. Chicagoans have had a chip on their shoulder for over a century, and traders often portray this head-butting as epic, their struggle to bring much-needed transparency to New York’s murky markets.

The teams fought it out at the Chicago Board of Trade, long the dominant exchange in Chicago, in the boardroom and in the clearinghouse. On one side, you had smaller firms owned by Chicago guys. On the other side, you had representatives from New York firms like Goldman Sachs and Morgan Stanley. A few years ago, the New York firms won the clearinghouse. That became, to a large extent, the reason that the two Chicago futures exchanges merged in 2007. The rallying cry was to save Chicago from New York.

The current derivatives duel is the latest fight, and it could have been Chicago’s moment of triumph. The Chicago crowd made a jab for transparency when CME Group teamed up with Kenneth Griffin at neighboring Citadel Group to create an exchange that would make the derivatives trade less murky. Congress, in its attempt to bring order, took a page from Chicago’s playbook and instructed the bankers to use clearinghouses, a staple in futures.

But as Story recounts, the banks didn’t like the exchange idea. “So the banks responded in the fall of 2008 by pairing with ICE, one of the Chicago Mercantile Exchange’s rivals, which was setting up its own clearinghouse.” CME Group, she later writes, dropped the effort with Griffin to create an exchange and instead has allowed its clearinghouse’s risk committee be “mainly populated by bankers.”

Chicago has represented something special over the years, a counterpoint to Wall Street. Its futures market wasn’t perfect, but it worked. When Wall Street’s derivatives market broke down in 2008, Chicago rightly held its regulated market, its way of doing things, up as a potential model. It may be too simplistic to say that one model is right and the other wrong, but the challenge itself is vital. Especially in a complex business like this one, you need different ideas and sparring to keep the game honest.

Now Chicago’s exchange is a public company. Duffy and Donohue are tasked with maximizing shareholder value. The banks are directly or indirectly responsible for the vast majority of derivatives trading, and CME Group has to involve them in decisions. But it doesn’t have to sell out to them. In Story’s story, CME Group looks less like a counterpoint to Wall Street than like the Midwestern arm of it. I hate to think that the rivalry is dead. There are plenty of people in Chicago who seem to hate New York with a passion I associate more with religion or the Bears (ouch, by the way). I hope that in this fight, which could prove decisive, those people recover their voice.

Kenneth Anderson:

Although I have a few reservations about the tone of the article being just slightly conspiratorial, Louise Story’s front page NYT story today on the evolution of derivatives clearinghouses is highly informative and very well done.  The graphics showing how the bilateral trades would turn into centralized clearing are quite good and would be useful with a class.  On balance,  I think the overall shift to centralized clearing is a good move.  But I also have a bad, bad feeling about this in the context of Dodd-Frank and future expectations.  As I have said in past posts, in a future of financial regulation in which the central question of systemic risk and moral hazard has not been addressed, the result of what is otherwise a sensible move (yes, yes I’m skipping over all the concerns about end-users and Main Street, etc.) could turn out to create not so much a central clearing house but instead … a central address for depositing unwanted risk.

After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis?  And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea — if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.

Presumably the answer is that government regulators will set those requirements and solve the problem.  But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions.  Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first.  I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham.  The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it.  The clearing house might turn out to be the one address market participants need to send their unwanted risks.

Kevin Drum:

Banks can talk all they want about capital requirements and governance structures, but if they’re unwilling even to admit publicly who runs their clearinghouses, it’s pretty obvious their primary interest is focused on keeping the derivatives club very, very small and very, very private. In other words: no aggressive competition needed here, thankyouverymuch. Big commissions and big bonuses will remain the order of the day.

Unless, of course, regulators take a tough line and force banks to genuinely open up derivatives trading. What do you think are the odds?

Anthony McCarthy

Barry Ritholtz at The Big Picture:

I keep coming back to this simple fact: If you understand what caused the crisis, the first step in preventing another is working backwards and undoing each of the causes. Front and center is the Commodity Futures Modernization Act that allowed the rampant shadow banking system to develop. It still needs to be overturned . . .

Philip Davis at Seeking Alpha:

The secrecy surrounding derivatives trading is a key factor enabling banks to make such large profits and the banks guard that secrecy very closely. In theory, the Dodd-Frank bill will eliminate much of the abuse that is going on in the derivatives market. But already, the newly-elected House and Senate Republicans are looking to turn back to clock. This is apropos because, as Barry Ritholtz points out: It was the dreaded Commodity Futures Modernization Act that allowed the rampant shadow banking system to develop.

John Carney at CNBC:

Half of Story’s piece seems built around the complaints by financial companies—such as Bank of New York Mellon and State Street—that want to become clearing dealers for derivatives. The other half is built around customers who feel the fees they pay to existing dealers are too high—thanks to the anti-competitive cabalization of the derivatives market.

The irony of all this, of course, is that the cabalization of the derivatives market was one of the goals of regulators, who demanded that market participants set up centralized derivatives clearing houses in an effort to contain counter-party risk. Central to the successful operation of any such clearing house, however, is the exclusion of would-be dealers who seem too risky.

One of the ways a centralized clearing house reduces counter-party risk—that is, the risk of someone on the other side of your trade not doing your deal—is by being the strongest and biggest counter-party that is on the other side of every trade. The idea is that even if a single seller fails—and doesn’t deliver on the sale—the derivatives clearing house has access to enough capital and liquidity that the trade itself can still be completed. You don’t have to worry, in other words, who is on the other side of your trade—it’s always the clearing house.

Importantly, however, a clearing house has to guard against the possibility of its members failing. Without proper capitalization and collateralization requirements, the clearing house could find itself unable to complete trades in a time of financial distress. It would go from being a risk-reducer to a risk-multiplyer, with all the risk concentrated in one place.

The odds of getting a clearing house that is properly capitalized are rather low on the face of it. Competition between clearing houses will result in a downward pressure on fees, collateral requirements, and dealer capitalization requirements. In short, the clearing house will be captured by its customers in a manner that undermines its financial soundness.

To make matters even worse, the natural market counter-balance to this pressure toward riskiness on the part of the clearing house is undermined by the perception—indeed, the reality—that any important clearing house is too big to fail. In a free market, the customers of a clearing house would balance out the demand for lower collateralization/capitalization/fees with a wariness about the increased risk associated with this lowering. But in reality, customers don’t worry about a major clearing house failing because the US government will intervene to bail it out.

This is, ordinarily, an argument made by proponents of government regulation. The tendency toward riskiness plus moral hazard means the clearing house cannot be self-policing. To balance out this situation, the government steps in an imposes collateralization and capitalization requirements on the clearing house. There’s even a sort of fairness argument here—the higher costs associated with the regulations are paying for the implicit guarantee.

If we could be confident in the competence of regulators, the story might end there. Unfortunately, regulators have a poor track record of regulating risk. On the one hand, they often simply lack the tools to effectively predict risk—which means they are simply guessing about the types and levels of capital and collateral that should be required. On the other hand, they are subject to political pressures that influence their view of risk. So what starts out as an educated guess winds up as a politicized guess.

If that’s too theoretical, here’s an example drawn from history. In the 1980s, global regulators were meeting to discuss bank capital requirements. One of the issues at hand was what risk weighting different assets should get. All of the countries agreed that their own highly rated sovereign debt should get zero percent risk weighting—which essentially meant that banks didn’t have to set any capital against losses. Ask the banks with Irish and Greek debt how that is working out.

The same global regulators argued about what risk weighting to give mortgages. The Federal Reserve thought mortgages should get a 100 percent risk weighting—the same assigned for highly-rated corporate debt, and requiring an 8 percent reserve against losses. The West Germans, however, wanted to gin-up interest in their residential real estate market and pushed for a 50% risk weighting. This risk weighting more or less held through the later capitalization reforms, resulting in banks over-investing in mortgage-backed securities. How’d that work out?

So we’re left with a problem from hell. Market participants cannot be trusted to govern a clearing house. The clearing house itself cannot be trusted to be self-governing. And the regulators cannot be trusted to govern properly either.

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I’d Like To Be Under The Sea, In A Commercial Mortgage Garden In The Shade

Andrew Ross Sorkin‘s Dealbook at NYT:

Elizabeth Warren, head of Congressional oversight for TARP and a major backer of the idea of a consumer protection agency, told CNBC on Monday that the U.S. economy still had a hard road ahead.

“By the end of the year, about half of all commercial real estate loans are gonna by underwater, and they are concentrated in the midsize banks,” she said. (Short-sellers, at least, may have something to look forward to.) “We now have 2,988 banks that have these dangerous concentrations of commercial real estate lending.”

She said that the banks’ exposure to shaky commercial real estate would have two upshots: 1) since they were already suffering since the subprime crisis, their stability might be affected; and 2) the midsize banks “are the banks that are supposed to be doing small business lending, and when they’re getting a sock in the teeth over over commercial real estate loans, they’re not in a position to be lending to small business,” Ms. Warren told CNBC.

“I think we have another very serious economic problem that we’re going to have to resolve in the next three years,” she said.

Philip Davis at Seeking Alpha:

An example of how fast things are falling apart on the CRE side is LNR Property Corp, who are managing $22Bn worth of distressed CRE loans which were obtained through the discounted purchase of CMBS. As a workout shop, LNR either negotiates with borrowers to make a loan current or forecloses on the property to extract as much cash as possible from the delinquent mortgage. And while LNR used to make a nice profit working out the occasional bad loans, now the company and its competitors face a flood of bad debt. “It’s tough going for everybody right now,” said Lisa Pendergast, managing director of CMBS strategy and risk at Jefferies & Co. and the incoming president of the Commercial Real Estate Finance Council. ``I don’t think anybody built these [workout] shops to see these huge volumes of loans going bad.”

By LNR’s estimate, the front is widening with no relief yet visible on the horizon. We’re seeing vacancy rates in most markets going up. We’re seeing rental rates in most markets going down,” Ronald Schrager, LNR’s chief operating officer, told a recent real estate conference in Miami Beach. “There’s still a lot more distress ahead of us.” This distress is not isolated in Florida either – Downtown Manhattan, which had, until recently, seemed immune to the CRE problems, is about to lose its spot as the best-performing U.S. market. Vacancies may exceed 14 percent of the area’s 87 million square feet by late 2011, empty space that’s equivalent to four Empire State Buildings and is the highest rate since 1997. “The amount of space that’s potentially going to come to the market will increase availabilities and put pressure on pricing,” said Kenneth McCarthy, Cushman’s head of New York- area research. “It will be quite awhile before it can be absorbed.”

Mark Hemingway at The Washington Examiner:

On the plus side, Warren seems to be aware that Fannie Mae and Freddie Mac are disasters for the taxpayer:

// //

Speaking on troubled mortgage lenders, Warren said it’s time for the government to “pull the plug” on mortgage lenders Fannie Mae and Freddie Mac.

“I’m one of those people who never liked public-private partnership to begin with. I think what they did was use public when public was useful and private when private was useful,” she said. “And I think we’ve got to rethink that whole thing.”

But before you get too hopeful, bear in mind that this is also the same Elizabeth Warren who thought that bailing out the mortgages of vacation homes was a good idea.

James at Bubble Meter:

I also think we should pull the plug on AIG and the FHA. AIG is a zombie. The FHA is just getting into deeper and deeper financial trouble, all in an effort to prop up home prices above their intrinsic value.

Megan Carpentier at The Washington Independent:

Elizabeth Warren warned in February that commercial real estate was the next recovery-killer, and since nothing improved by March, Tim Geithner yesterday took to CNBC to acknowledge the problem with commercial real estate and push the administration’s program to incentivize small banks to lend to small businesses as the solution.

One way to help manage the commercial loan distress, Geithner said, is through the $30 billion fund proposed by President Barack Obama to provide money to midsize and community banks if they boost lending to small businesses.

He did not clarify how giving money to some banks for an entirely unrelated purpose would solve a commercial real estate crisis.

Earlier in the day, TARP Congressional Oversight Panel chair Elizabeth Warren warned that more than half of commercial real estate would be underwater by the middle of 2010.

“They are [mostly] concentrated in the mid-sized banks,” Warren told CNBC. “We now have 2,988 banks—mostly midsized, that have these dangerous concentrations in commercial real estate lending.”

In February, Warren noted that $1.4 trillion in commercial real estate loans would need to be refinanced between 2011 and 2014 when the shorter-term commercial real estate mortgages end, and a significant proportion of those are underwater already. More than $50 billion in commercial real estate mortgages are already in default or foreclosure — both figures are far larger than Geithner’s $30 billion plan to extend credit to small businesses. Sheila Bair, the chair of the FDIC, expects that commercial real estate defaults and losses will be the number-one factor that drives small and medium-sized banks into failure this year at a higher rate than they experienced in 2009. Extending credit to small businesses to the tune of $30 billion doesn’t seem like the best solution to the coming commercial real estate crisis or its downstream effects on businesses or the banks holding the loans.

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