OTC Derivatives Reform: The Parade of Mendacity Continues

by: Karl Denninger

The Parade Of Mendacity continues in the Capitol today, with a committee hearing on the reform of the OTC Derivatives market.

The witness list reads as a who's who of the den of wolves, of course. We have the obligatory commercial interests who use derivatives (Cargill and John Deere) along with SIFMA via Morgan Stanley (NYSE:MS), the Managed Funds Association, the insurance companies (Prudential) and the mandatory academics.

Many of the witnesses make the obvious point that derivatives are useful to hedge off risks of various types, some of which are "custom" in their implications - that is, there is no currently-corresponding exchange-traded instrument that duplicates what they are trying to accomplish. In this they are correct.

But two pieces of testimony are deeply troubling; those of James Hill and Dave Hall of SIFMA and Chatham Financial, respectively.

James asserts as his opening volley:

We believe that a guiding principle for congressional action should be not to impose new regulations that will limit the availability or usefulness of derivatives or increase their cost unless there is a compelling reason to do so.

In other words, James asserts that there should be no regulation that provides for actual safety improvements to the system, because such improvements will of course increase their cost.

He goes on to say:

It was the lack of meaningful regulation of AIG’s derivatives affiliate that allowed poor business practices to lead to a situation in which the federal government had to invest tens of billions of dollars in that enterprise in order to avert what could possibly have been a systemically significant business failure. The Act would address this regulatory shortcoming by creating a legislative and regulatory framework that ensures such a lapse should not occur again.

That's a nice sentiment, but it does not take Mr. Hill long to gut his own prescription. See, AIG's problems revolved around a simple reality: It was operating while insolvent, and allowed to become not only insolvent but ridiculously insolvent, to the point that it literally threatened to be unable to cover ANY of its outstanding derivative positions.

SIFMA's position becomes clear almost immediately thereafter:

For example, the Act would authorize regulators to impose margin requirements on swaps in which one of the counterparties is an end user. It is difficult to understand why counterparty credit exposure created through a swap transaction should be required to be collateralized when lending arrangements between the parties can be made on an unsecured basis. The Act would direct regulators to allow parties to post non-cash collateral, but even that carries a cost, including reducing the end user’s borrowing capacity and potentially causing an end user to violate negative pledge covenants.

There's the problem with the banking system right there - in your face! We had multiple failures last year because banks lent money unsecured beyond their excess capital; when that money was not paid back by the supposedly-credit worthy customers in a sufficient number the bank failed, forcing the intervention of the Federal Government.

Worse, we have hard proof that this conduct is still going on in the form of nearly 100 bank failures thus far in the crisis. In virtually every case it is discovered that these banks are not just insolvent, they are ridiculously beyond insolvent, having burned through their so-called 6% Tier One regulatory capital three, four, five or even six or seven times over before being "caught" and closed.

These deficiencies did not happen overnight. Indeed this sort of insolvency takes weeks, months or years to develop, during which there has been willful blindness both in Washington DC and the several States to the pending implosion of these firms. In many states, such as Virginia, Michigan, Maryland, Nevada, North Carolina, Indiana, Missouri this is defined as an offense, and some states define it as a criminal felony for which one can be imprisoned for a term of years. All of the above named states define such an offense as one that subjects all officers, directors, and branch managers to personal liability for loss of such deposits, and demands personal knowledge of the books of account of such institutions by all these individuals. While some states apply this only to "state banks", others are far more broad, applying these strictures simply to "banks", strongly implying that these standards apply to any firm that operates a bank in their state by virtue of corporate charter (as a foreign corporation or not!)

Now SIFMA has the gumption to come to The House of Representatives and put forth the position that institutions are "free" to do this sort of thing, exposing themselves to insolvency via lending, they should be able to expose themselves to even greater insolvency via derivatives contracts, and that no margin supervision should be required as a matter of law in order to prevent insolvency from occurring.

This is tantamount to asking for official federal sanction to commit a felonious act under the laws of several states.

Another provision concerns dealer segregation of funds or other property posted as margin. We believe it is important for end users to have that option in connection with over-the-counter swaps, but both the decision to require margin and the details of how it is handled should be left to negotiation between the dealer and the end user in the ordinary course of their lending and risk management processes.

Both Lehman and AIG's failures were systemically significant as a direct consequence of the failure to demand margin segregation.

Lehman is particularly troubling. As I have previously documented there were tens of billions of dollars in NY Fed money that Lehman had outstanding at the time of its bankruptcy filing. What appears to have transpired, however, is that The NY Fed was repaid in apparent violation of bankruptcy preference laws after the petition was filed, even though such actions are per-se improper once an insolvency is declared by the firm (indeed, any payment made that appears to be in "preference" looking back prior to the filing for a reasonable time, usually 90 days, can be reversed in bankruptcy.)

The larger issue is simply this: SIFMA is arguing that collateral posted with a bank or other financial institution to secure a current liability under a derivative contract should be available to the institution for general corporate purposes. This runs contrary to every principle of fiduciary responsibility, agency status for a broker/dealer and common sense.

Indeed, these funds are not, under any circumstances, the broker/dealer's to use. They are posted as security for performance, just as is an earnest money deposit on a home purchase or margin posted for a short stock position. These funds are collected for the express purpose of securing performance, nothing more or less, and they need to be held and kept separate under formal escrow protection.

The legislation under consideration does not go far enough to guarantee this protection for customers. Under no circumstances should the assets of a customer that are posted for margin purposes be able to be co-mingled with the general operating funds of the corporation holding them, nor should they be subject to seizure and conflation with the firm's assets in the event of insolvency. The money or other collateral in these instances is posted for the specific purpose of securing performance; nothing more or less, and does not belong to the institution holding these funds!

SIFMA's objection is both self-serving and outrageous. By permitting the corporate use of these funds not only are the banks able to "double dip", that is, earn interest lending out money that is not theirs, effecting theft (even if temporary) by conversion, they also expose customers to the risk of loss in the event of a firm's insolvency - a risk that is not disclosed clearly and conspicuously to them when they enter into these derivatives contracts. Indeed with that disclosure it is likely that no customer in his or her right mind would agree to such a contract, as the very time when a loss occasioned by this would be realized would be when that firm would be making maximal use of its hedging activity via these derivatives.

I will note for the record that other institutions have been caught using customer segregated funds generally for their own corporate purposes in recent years, and subjected to fines for doing so. This is insufficient; such a violation should be punishable by criminal sanction as well as revocation of a firm's operating charter, as this is nothing more or less than theft by conversion.

Dave Hall echoes the sort of ridiculous statement of SIFMA with regards to margin:

Margin – Any requirement for business end users to cash collateralize hedging transactions would create an extraordinary and unnecessary drain on working capital.

Huh? The exposure on a short transaction that has gone "against" the customer is real! The requirement to post margin comes out of the fact that performance, assuming the position remains where it is or continues to move adversely, will require the payment of those funds. Posting of margin may "drain working capital" but so does performance! What will be next? Repudiation of swaps that go the wrong way for the customer?

Mr. Hall goes on to say:

To illustrate this point, a bank may choose to make a loan without collateral if the business is creditworthy, therefore it is reasonable that a derivative should be allowed to be offered to a business end user without margin if the business end user is creditworthy.

And again I note that we have nearly 100 proved cases thus far in the form of bank seizures where so-called "credit-worthy" customers in fact were not and the refusal of those institutions to maintain the sound banking practice of never lending unsecured beyond the bank's own collateral has resulted in insolvency from three to nine times over (vis-a-vis the Tier 1 Regulatory Capital) prior to seizure.

In short OTC derivatives, over the previous ten years, have become a mechanism for avoidance of sound financial regulations and gross abuse of regulatory arbitrage. These abuses have led to billions of dollars of losses in the case of Lehman and taxpayer expense of over $100 billion dollars that was passed through AIG to counterparties that, on their face, had a claim to exactly nothing following AIG's recognition of inability to pay as agreed.

These failures were not accidents, they were systemic and intentional abuses that, under the laws of several states, should have been charged and prosecuted as felonies. That there is no corresponding federal law prohibiting a financial institution from accepting funds and/or operating while it is in a negative equity position and criminalizing this conduct - that is, operating while insolvent - is an outrage.

SIFMA and The Chatham Financial Corporation wish to not only continue this charade but, it appears, to be given formal permission from The Federal Government to expand it.

Their requests not only must be denied but Congress must also write into law criminal penalties mirroring that of states such as Nevada, which formally define the operation of a "bank" (but extending it to all financial institutions) while insolvent as a felonious act, exposing all officers and directors not only to prison time but also to personal liability for all losses suffered by customers and counterparties as a consequence thereof.