The Real Reason the Big Boys Don't Want Credit Default Swaps to Be Regulated

Bloomberg has an article today quoting a couple of congress people acting as spokesmen for the 5 biggest banks:

Freshman congressman McMahon told House Financial Services Committee Chairman Frank he was worried that Obama’s derivatives plan, released in August, would penalize a wide swath of U.S. corporations and could push jobs in his home district overseas, McMahon said in an interview.

“It’s not just the farmers, and it’s not just the Wall Street guys,” said McMahon, a member of the New Democrat Coalition, a group of 68 self-described pro-growth Democrats in the U.S. House of Representatives. “It’s across the nation. American industry uses these products for a very useful purpose, which keeps down prices and makes consumer products cheaper.”

McMahon said Frank agreed it was important to protect so- called end-users, the corporations that rely on derivatives to hedge everyday operational risk, such as fluctuations in foreign currency rates, interest rates and commodity prices. The Obama plan would subject companies to higher collateral requirements whether they trade standardized or customized contracts. It also calls for most trades to be executed on an exchange or an “alternative swap execution facility.”

Are McMahon and Frank right? Are derivatives necessary to keep prices down and make consumer products cheaper?

Well, initially, we are in a deflationary environment, largely caused by the use of massive numbers of credit default swaps (see this article by Newsweek; and even former SEC chairman Christopher Cox said: "The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis'') . So I guess, in that sense, the use of CDS has reduced consumer prices.

McMahon and Frank are also lumping credit default swaps and other risky credit derivatives in with derivatives pegged to currency, interest rates and commodity prices. The above-described types of derivatives are apples and oranges, and treating them as if they were the same is a recipe for disaster. If these congressmen don't know the difference between derivatives related to credit risks and derivatives related to currency, interest rates and commodity prices, then they should not even be let into the Congressional building for derivatives hearings, let alone given a podium and a microphone.

As to CDS, leading derivatives trader and expert Satiyajit Das wrote a must-read article pointing out the falsity of the justifications used by both buyers and sellers of credit default swaps and other complex forms of "financial innovation":

The unpalatable reality that very few, self interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.

Das is not alone. The top derivatives experts all say (except those who work for the too-big-to-fail banks) that CDS are incredibly dangerous, don't provide much benefit to the consumer or the economy as a whole, and must be reigned in.

The Bloomberg article goes on to give the real reason that the TBTFs and their many lapdogs in Congress don't want CDS regulated:

The change [in Obama's proposed regulation being championed by McMahon and Frank, which even the guy who formerly blocked regulation is now saying is too weak] could protect billions of dollars in profit for the dealers. When securities or derivatives are traded on exchanges -- where investors can see real-time prices, rather than indicative prices sent by e-mail in the over-the-counter market -- it can shrink the amount that dealers make on each trade, known as the spread.

“Having more discretion for the dealers in the regulations gives an extra benefit to them by staying away from narrower spreads,” said Darrell Duffie, a finance professor at Stanford University in California.

The top five U.S. commercial banks, including JPMorgan, Goldman Sachs and Bank of America Corp., were on track through the second quarter to earn more than $35 billion this year trading unregulated derivative contracts, according to a review of company filings with the Federal Reserve and people familiar with the banks’ income sources.

The banks are arguing that an exchange or trading-system mandate that publicizes large trades could make it too expensive or impossible to execute customer orders and hedge those trades at the same time, according to the people familiar. Publicized large orders may dry up the willingness of dealers and investors to buy or sell contracts, they said...

Not mandating exchange or other types of electronic trading “will probably prevent spreads from dropping like a rock,” said Kevin McPartland, a senior analyst in New York at Tabb Group, a financial-market research and advisory firm...

In other words, beneath all of the fancy arguments from the TFTFs and their mouthpieces in Congress, the real reason that they don't want CDS regulated is because it will narrow the spreads, and they will make a little less money. In addition, transparency would reduce the market, because investors would see CDS as the snake oil that they are (outside of some very narrow, specific uses).

The TBTFs couldn't care less that a huge, unregulated CDS market will destabilize the economy and lead to crises in the future.

Why should they? As Nobel prize-winning economist George Akerlof predicted in 1993, the financial giants would use CDS until the system crashed, knowing that the taxpayers would bail them out when the crash happened.

They know the same thing will happen tomorrow . . .

The bottom line is that we are now in a system where gains are privatized and losses are socialized (and see this). The debate over CDS is really one part of the larger debate as to whether that system will continue or not.