Total U.S. demand deposits are around $1 trillion. China and Japan each hold around $1 trillion in U.S. Treasuries.
The gross market value of outstanding credit-default swaps is larger than any of those. The total notional value of these swaps has reached almost $30 trillion — reflecting astronomical, opaque counter-party exposures.
I doubt there has ever been an industry or product line that expanded so fast or got so big without attracting serious scrutiny.
We're told that's a good thing, because market participants allegedly use derivatives to hedge (reduce or neutralize) risks inherent in their businesses.
If I purchase a credit default swap today, I won't be hedging anything, I'll be taking on risk — and the ultimate seller may not be hedging either. AIG wasn't.
During the decade ending in 2007, the financial industry, along with derivatives, expanded immensely — and volatility then exploded to a crisis as credit-default swaps volume peaked.
Can anyone claim that without derivatives, the result would have been even worse? Higher volatility, a more calamitous collapse?
People bought credit-default swaps on collateralized debt obligations or other mortgage-backed securities as a substitute for selling the mortgages short, which was not feasible. The consequences passed from derivatives to the housing market, which was seriously and lastingly damaged:
1. Without the demand for credit-default swaps on them, there would have been less of the bad securities marketed. Billions in toxic securities were created to meet the demand for credit-default swaps on them.
2. With less of the bad securities issued, there would have been less demand for the bad mortgages — for which the securities underwriters generated uncritical or perverse buying power.
3. Fewer bad mortgages would have meant less of a housing bubble, fewer foreclosures, and lower losses hitting bank balance sheets. As simple as 1,2,3.
Many people worked hard to reduce risk, but accomplished nothing significant. Bank examiners, seemingly almost without exception, were unable to distinguish mortgages with stated income from those with verified income. Unable to distinguish a 100% LTV payment option mortgage from an 80% fully amortizing mortgage. Should we have faith that these same examiners will unravel derivative and other off-balance sheet risks, including systemic counter-party exposures? I doubt it.
In important respects, derivatives have been and remain effectively unregulated as a result of explicit exemptive provisions of legislation passed in 2000, which were modified only in a limited way by Dodd-Frank. Even these modest restrictions are under relentless attack.
There's no legislation or regulation yet in place that directly addresses the demonstrated potential of derivatives to distort demand for real assets and in fact pump demand for bad assets. How could anything in Dodd-Frank ever accomplish that?
Credit risk is inherent in debt securities and loans. Using credit-default swaps to neutralize credit risk while accepting the other risks inherent in debt — risk of changes in the risk-free yield curve and in some cases prepayment risk — is illogical. Acquiring an interest in an entity's debt means accepting that entity's credit risk.
Any two people can bet on an insolvency, just as they can bet on a football game or on the weather. To allow and facilitate such betting by regulated entities will increase volatility and systemic risk by exacerbating the adverse consequences of insolvencies. I'm not permitted to buy life insurance on a stranger's life. Why can I buy it on a corporation?
The prevailing thesis seemingly underpinning (non)-regulation is that all of this is too complicated, and anyway it's excessively difficult to distinguish arbitrage or hedging from speculation. But, would the system be safer with None of The Above? Where is the evidence to the contrary?
More fundamentally, if we constrain the assets and liabilities of insured entities, then why exempt off-balance sheet contracts from any meaningful scrutiny? If examiners don't understand them — and they surely don't-then how are we protecting the deposit insurance funds against irresponsible behavior?
The economic damage wrought by the "Tulip Mania" in seventeenth century Holland was not the consequence of cultivating tulips. It resulted from unlimited proliferation of financial contracts that were untied from any real asset flows: futures, derivatives. This was exacerbated by feeble and misguided attempts at regulation, which expanded the risks.
Undoubtedly, many of the losers would have said that they were only engaged in hedging — and were highly confident of being well hedged.
Regulate explicitly and examine competently the off-balance sheet contracts of banks. Reduce the incentive for torrid marketing of derivatives that results from lack of centralization of trading and the consequently excessive risk-free spreads for "dealers." Expose counterparty liabilities and regulate them.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian. He can be reached at firstname.lastname@example.org.