Monday, May 18, 2009

The illusion of CDS regulation

I cannot recommend enough reading through the Institutional Risk Analytics newsletter.   This is the source for understanding bank solvency and the regulatory issues surrounding the current banking problems.  This particular piece discusses how the major investment banks have hijacked the process of regulating credit default swaps.  Another prime example of how regulators are held captive by the industries they regulate.  Here's a tidbit:

Why such a desperate battle for the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

1 comment:

Hershblogger said...

Thanks, Mitch.

I've added the newsletter to my blogroll. Well worth reading.