William D. Cohan on Wall Street and Main Street.Tags:
Gather round people, today we are going to discuss the highly opaque but hugely important topic of “O.T.C. derivatives,” or securities that derive their value from other securities and are traded between institutions “over-the-counter,” rather than on an exchange where they can be more closely regulated and monitored. Examples of such derivatives are an option to buy a stock in the future at a fixed price set today and credit-default swaps, a form of insurance against the future default of a bond.
Admittedly, this subject can be tough sledding. But it’s important to keep up — having some understanding of these securities is essential to coming up with a way of regulating them, which in turn is vital to helping to prevent another financial crisis. While President Obama didn’t mention them specifically in his comments on banking reform on Thursday, they should certainly fall under any new legislation. And for good reason: Some seven years ago, Warren Buffett, the world’s best and most admired investor, tried to enlighten us about the dangers of derivatives by describing them as “time bombs, both for the parties that deal in them and the economic system.” Few listened to the Oracle of Omaha then, but not for nothing is Buffett the world’s second richest person.
We must regulate over-the-counter derivatives or risk them blowing up the economy once again.
Over-the-counter derivatives finally got some of the public attention they deserved last week, at the tail end of the first day of testimony of the top executives of Goldman Sachs, Morgan Stanley, JPMorgan Chase and Bank of America before the Financial Crisis Inquiry Commission, which Congress set up to figure out how and why the financial crisis happened. What is clearer than ever after the colloquy between Brooksley Born, a commissioner and (famously outspoken) former chairman of the United States Commodities Futures Trading Commission, and Lloyd Blankfein, the chief executive of Goldman Sachs, is that the ongoing failure to monitor the trading of derivatives on a formal exchange — as most stocks and bonds are — was one of the major, albeit least understood, factors contributing to today’s economic mess. The problem was that valuing these securities became nearly impossible, and yet so much depended on that valuation. Keep reading.
When Born asked Blankfein the money question of what role unregulated derivatives played after a number of entities (Lehman Brothers, Washington Mutual, Fannie Mae and Freddie Mac) defaulted on their debt and another bunch (Bear Stearns, American International Group and Merrill Lynch) almost did, Blankfein responded, “Aspects of the over-the-counter derivative market were a very, very big concern and a big worry, so much so that a lot of institutions — all of the institutions here, I believe — were working very, very hard to make sure that things would settle and that things would clear.”
What about A.I.G., which only avoided default thanks to an emergency government infusion of $85 billion last September (since increased to a taxpayer gift of $182.5 billion)? “A.I.G. was bent on taking a lot of credit risk,” Blankfein explained. “They took that credit risk in the derivatives market. They took that business by writing insurance against credit events. They took it by holding securities. It was a failure of risk management of colossal proportion.”
Blankfein said the world was “lucky” that most derivatives trades “settled and cleared” during the crisis and agreed that “standardized” derivative contracts should be traded on an exchange, although specialized “bespoke” contracts — the example he gave was if an oil trader wanted to hedge the price of a certain kind of oil — should still be allowed to trade off an exchange. “What could be on an exchange should be on an exchange,” he said.
That Blankfein and Goldman Sachs should be publicly supportive of moving most derivatives trading to an exchange — perhaps the most important provision of the Wall Street Reform and Consumer Protection Act of 2009, which has passed the House — is a remarkable turn of events. “This will do more to enhance price discovery and reduce systemic risk than, perhaps, any specific rule or regulation,” Blankfein stated in his written testimony. During the hearing, Blankfein readily admitted that the lack of a derivatives exchange caused Goldman any number of headaches when it came to getting A.I.G. to pony up the collateral Goldman was demanding on the trades the two firms had set up.
On the face of it, these trades were fairly simple. A few years back Goldman started betting that the mortgage market would fall; A.I.G. bet it would not. As the market went Goldman’s way in 2007 and 2008, and mortgage securities started losing value, Goldman started demanding more and more cash from A.I.G. — cash A.I.G. soon ran out of. “The issue we had with A.I.G.,” Blankfein explained, “we would have avoided” had there been an exchange.
Now, folks, listen up, because this is where things get tricky. What Blankfein didn’t get around to discussing — in fairness, he wasn’t asked — was the role Goldman played, either wittingly or unwittingly, in precipitating A.I.G.’s liquidity crisis. To gain some understanding, we are going to have to look more deeply into those trades that Blankfein called his “issue” with the insurer.
In December 2006, the top executives at Goldman, including Blankfein and David Viniar, the chief financial officer, became bearish on the mortgage market and started to mark down aggressively the value of the firm’s portfolio of mortgage securities and also began shorting them, betting their value would fall. According to a report done by A.I.G., by November 2007, while other firms like Merrill Lynch valued a certain mortgage security at 90 cents on the dollar, Goldman valued it at 67.5 cents on the dollar. That’s a huge gap among traders who are all supposed to be sophisticated.
Because it placed such a low value on these securities, Goldman demanded more and more cash collateral from A.I.G. to make up the balance of the trade. (After A.I.G. lost its coveted AAA credit rating in 2005, Goldman had a contractual right to demand collateral on the spot.) Throughout 2007 and 2008, A.I.G. disputed Goldman’s valuations but Goldman kept pushing and pushing for more cash. A.I.G. ended up giving Goldman a large percentage of what it demanded, but not everything. Goldman’s valuations slowly but surely trickled into the market and other Wall Street firms began pushing A.I.G. for more collateral as well. Finally, A.I.G. simply ran out of money, and was on its way to following Lehman Brothers into bankruptcy court. That’s when the Fed stepped in.
The really interesting thing about Goldman’s collateral demands on A.I.G. was that, once upon a time, derivative contracts, as drafted by the International Swaps and Derivatives Association, had a provision whereby any collateral disputes were to be settled at the end of the contract, often many years into the future. That changed in 2005, when the association altered the standard contract form so that collateral disputes would be settled monthly. (While the reasoning behind this change remains murky, Hank Greenberg, the former chief executive of A.I.G., has said that Goldman Sachs pressured the association into it. In response to my queries, however, the swaps and derivatives association denied any Goldman role.)
Just as it is more than valid to wonder what A.I.G. was thinking in the first place by insuring all of these crazy risks, it is also all but certain that these monthly disputes — between first Goldman Sachs and A.I.G., and then between A.I.G. and all its other counterparties — almost certainly precipitated the insurance company’s collapse and its subsequent bailout. But given the secretive nature of the over-the-counter market, it’s hard to piece together exactly what occurred.
Brooksley Born, who has been pushing for the proper regulation of derivatives ever since she became head of the futures trading commission in 1996, is certainly wise enough to get to the bottom of what role Goldman played, if any, in getting the International Swaps and Derivatives Association to change its contractual approach to the collateral calls, and how this change put huge liquidity pressures on AIG at the very moment when it could least handle them. Perhaps she could send Lloyd Blankfein a follow-up note, with a subpoena attached, seeking an answer. And that’s our lesson for today.