Wednesday, February 3, 2010

Will Wall Street Get a Pass on Derivatives Reform?

Both Republicans and Democrats, in the rush to seize the momentum of today's neo-Populism, are buying up the entire denim overalls market and learning to chew straw. But they seem to have lost focus on the derivatives market, the place where the 2007-08 financial crisis began. Had it not been for the big Wall Street firms who created and underwrote vast quantities of mortgage-related derivatives, like CDOs, synthetic CDOs, CDOs squared, and other diverse and sundry bets and side bets on the values of all variety of assets, and their amen choir of money managers and investment advisers who drank avidly of some special lower Manhattan kool-aid before chanting that real estate values would never fall, we wouldn't be where we are today. The Great Recession was caused, first and foremost, by excess on Wall Street in the derivatives market. Profligate borrowing and overspending by consumers, and poor management by the U.S. auto companies and other corporations, were secondary problems that came into play only after the financial system froze up and required a multi-trillion dollar bailout from . . . well, you and me.

The most pressing problem in the derivatives markets is the lack of information. Investors don't know and can't easily learn what they've gotten themselves into. We can say that a thousand times, but let's recall the metaphor that a picture is worth a thousand words. There are very few pictures of the derivatives market, and they would only show a bunch of people in front of computer screens shouting into telephones. Tape recordings, however, fit the metaphor nicely. In financial dealings, what people say is much more important than how they look. As luck would have it, a few tapes of the goings on in the derivatives market have surfaced.

In December 1994, the SEC sued the securities broker-dealer subsidiary of a large bank called Bankers Trust. (In the Matter of BT Securities Corporation, SEC Rel. Nos. 33-7124, 34-35136 (Dec. 22, 1994)). As it happened, BT Securities taped recorded its derivatives sales people, a common practice on Wall Street as a protective measure against customers who try to avoid responsibility for their transactions. Of course, what's sauce for the goose can be sauce for the gander and for regulators, and the SEC got plenty of sauce from the BT Securities' tapes. As presented in the SEC's allegations (which BT Securities neither admitted nor denied), here are some of the tidbits found on the tapes.

BT Securities sold a company called Gibson Greetings (a greetings card company) customized derivatives called interest rate swaps that were meant to reduce Gibson Greetings' borrowing costs. These derivatives didn't trade in a market. Thus, there was no publicly quoted price for Gibson Greetings to compare BT's prices against. BT used computer modeling to determine the value of these derivatives. Gibson Greetings, which had to account for the derivatives on its financial statements, depended on information from BT to establish their values. Some of the derivatives were leveraged, with the result that small interest rate movements could produce large changes in value.

Gibson Greetings didn't fully understand the derivatives it bought--and BT knew it. A managing director at BT was taped saying, "from the very beginning, [Gibson] just, you know, really put themselves in our hands like 96% . . . And we have known that from day one." This managing director also said, "these guys [Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us." Thus, Gibson Greetings was at an informational disadvantage, and BT understood that was good for BT.

Many of Gibson Greetings' derivatives positions were losers. Gibson Greetings looked to BT for information about how much it was losing. BT apparently wasn't eager to give its customer bad news and understated the losses by millions of dollars. This lack of candor created a "differential" between Gibson Greetings' actual losses and the rosier picture it received from BT. The informational "differential" only exacerbated the problem. If BT had to unwind the positions, Gibson Greetings would be in for an unpleasant surprise. As a BT managing director put it," . . . the problem is that we are too far away between what he [a Gibson Greetings executive] thinks it is and what reality is . . . You know, we gotta try to close that gap." The managing director suggested more lies to offset the effect of the earlier lies: " . . . when there's a big move, you know, if the market backs up like this, and he is down another 1.3 million, we can tell him he is down another 2. And vice versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can say you have only made back a half a million."

A number of the derivatives BT sold to Gibson Greetings were supposed to reduce or offset negative effects of earlier derivatives Gibson Greetings had bought from BT. But, according to the SEC, BT did not disclose to Gibson Greetings that the terms of the new derivatives sometimes included unrealized losses or fees, totaling millions in the aggregate, that would make the transactions less beneficial to BT.

The SEC wasn't alone in getting BT tapes. In litigation brought by another BT client, consumer products giant Proctor & Gamble, more taped recorded statements were made public. In one conversation, two BT employees discussing a derivatives transaction with P&G allegedly said, "They [P&G] would never know. They would never be able to know how much money was taken out of that [in reference to large expected BT profits from the transaction]." The other employee allegedly replied, "Never, no way, no way. That's the beauty of Bankers Trust." See Another BT employee allegedly said about derivatives, "Funny business, you know? Lure people into that calm and then just totally f___ 'em."

The picture drawn by these tapes is that even large, successful business corporations have a hard time understanding complex financial instruments created by Wall Street and sold in an opaque environment. It's ironic that Wall Street apparently has recruited a number of its corporate clients to lobby against reform of the derivatives markets. If it's accurate that they don't fully understand what these financial products involve, there's a possibility they've been maneuvered by the potential predators into lobbying against regulatory reforms that could reduce the ability of the predators to victimize them. But if you don't know what you don't know, you might do yourself unknowing harm, especially if you lobby against rules to make you more knowledgeable.

There are no great or complex secrets about the basic problems in the derivatives markets. Information from these tapes showing the derivatives markets as it really operates, warts and all, has been publicly available for 15 or more years. We can see that the derivatives dealers are able to take advantage of even large, successful businesses because of the opacity of the market. Investors can't protect themselves because they don't have the necessary information; and in some cases may not even realize that they don't have the necessary information. A century after Louis Brandeis' famous observation, sunshine remains a superb disinfectant. Here are some of our suggestions for improvement, made over two years ago but still pertinent:

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