Tuesday, May 17, 2011

Lessons from AIG for Derivatives Clearing Houses

AIG's struggles to sell its $9 billion stock offering as a first step toward becoming a privately held company again remind us why the rather obscure lobbying battle over derivatives clearing houses is so important. AIG was Grand Central Station for high risk mortgage-related derivatives exposure at the time it was nationalized in 2008 in order to prevent its collapse and, with it, the collapse of the international financial system. Major banks that wanted to offload crappy tranches from mortgage-related CDOs and the like managed to persuade AIG to take a firm grip on the bag. When the mortgage market swooned, AIG was left holding the bag.

Almost no one, if one is generous with the benefit of the doubt, outside AIG--and perhaps even inside AIG--appeared to have realized until too late that the fate of the world's financial system and the world economy rested in the hands of an AIG subsidiary, AIG Financial Products Inc. This blog would become unduly lengthy if we detailed how incomprehensibly stupid shockingly large numbers of prominent people--inside AIG, among its counterparties, at its regulators, in Washington, and elsewhere--were in letting this situation come about. But one key consideration is that they didn't know in real time what was going on.

Much of the value of derivatives clearing houses is that they would collect information. With such information in hand, one could, comparatively quickly and easily, figure out where things might hit the fan. Although the question when things might hit the fan could depend on less predictable factors (such as the direction of the financial markets), we need to know if risk is again concentrated onto a single flimsy foundation capable of blowing up the world. Without clearing houses, that determination is exceptionally convoluted and time consuming. Examiners from the banking agencies, the SEC, the CFTC and myriad foreign regulators would have to fan out among numerous large financial institutions, each with a computer system that may well be incompatible with the computer systems of other major financial systems, and try to piece together where among untold numbers of attenuated or overlapping or circular derivatives transactions the hot potatoes have landed. The answer may well, as with AIG in 2008, come too late, from counterparties urging that taxpayers be dunned for yet another Wall Street bailout.

In the late 1960s, the stock markets had a record keeping crisis (the so-called "back office crisis"), where archaic paper-based systems couldn't provide the quality of settlement and clearance required for rising volumes of stock trading. Reputable brokerage firms collapsed or had to be merged with stronger firms, because their records were too messy to establish their financial viability. The SEC instituted a much more comprehensive regimen of improved settlement and clearance, record keeping, capital adequacy and examinations. Since that time, no large brokerage firm has collapsed or been forced into a shotgun merger because of back office problems.

Derivatives clearing houses could offer similar improvement to the markets. Detractors argue that they may present systemic risk themselves, by centralizing risk. But that is misleading. Because clearing houses would provide easily accessible information about the levels of risk they hold, either they and/or regulators can increase margin requirements (and required capital contributions from clearing house members) to provide a buffer against the centralized risk. That, in turn, would deter the taking of risks. While free market theorists (and bank executives at institutions that profit handsomely from their derivatives trading desks) shrink with horror at the notion of deterring risk, it was precisely the creation of too many mortgage-related derivatives, involving the origination of myriad exceptionally moronic no doc, no income, no asset, and no ability to repay loans, that fueled the inferno at AIG-FP. There is such a thing as too much risk, and we experienced it just a few years ago. Clearing houses would put a major barrier in the way of another such debacle.

Although hard core Soviets would blush at the way Wall Street today is revising history to blot out any mention of the 2008 derivatives catastrophe, we would invite history to repeat itself if we leave ourselves in ignorance again.

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