After 18 Years, Watchdogs Set to Leash Credit Swaps

RISK reports that the CFTC and SEC are partnering to oversee single-name credit default swaps, something required under Dodd Frank. This could bring to an end the damage, potential and actual, created by the product in the 18 years since the disastrous Commodity Futures Modernization Act of 2000 left over-the-counter derivatives completely free of regulation.

From RISK:

The top US markets regulators have reached a tentative agreement to jointly regulate single-name credit default swaps (CDS), has learned. The deal will pave the way for the Commodity Futures Trading Commission to propose a clearing rule for single-name CDS, fulfilling a key provision of the Dodd-Frank Act.

CFTC chairman Christopher Giancarlo discussed the agreement in a behind-closed-doors meeting with industry participants on March 13.

Neither regulator covers itself in honor on a regular basis, but the SEC is known to be more conservative in its views. Whether it will re-litigate the “insurable interest” question that CDS critics have leveled at those who take naked short positions (pretty much everyone in the market, that is), is unclear. But as RISK notes, this could be a step toward central clearing, moving credit products toward the same fate as interest rate derivatives, cratering dealer earnings but reducing systemic risk.

Unless, like me, you worry that clearinghouses just concentrate risk. But that’s another story.


Treasury Sets Stage for Financial Crisis Sequel

The good points in Treasury’s Dodd Frank reform priority list – in particular, acknowledging that cranking up regulatory capital requirements made the corporate bond market a LOT less liquid, and therefore prone to crisis – are overshadowed by one piece of truly head-shaking stupidity.

Treasury seems to have forgotten – or perhaps it never understood (or, more likely yet, just wants to cut its pals at the once and future wards of the state on Wall Street a break) – that it was all that super-senior synthetic CDO crap, requiring nearly no regulatory capital, that blew banks apart when the ratings firms realized their models were all wrong in 2007-08.

downloadBanks stuffed to the gills with that gilded manure – they couldn’t sell it, after all, initially because it yielded zilch and later because no one wanted to catch a falling knife – were suddenly insolvent when the three blind mice began their panicky widespread ratings downgrades and the squillions of super-senior crammed in banks’ attics suddenly started requiring – yup – lots of regulatory capital.

This proposal is doubly idiotic, since it assumes that investors will want to buy this stuff when it is declining in value, just when those investors themselves are scrambling to sell their own liquid assets to meet the true bogeyman of the crisis, the promised panacea that turned out to be the virulent contagion that spread the trouble from one basket of eggs to the next and pushing asset class correlations inexorably, painfully, toward 1 – the magic of collateral and margin calls.

From the FT:

The report seeks to soften bank capital requirements for securitised products, lowering some calculations in line with international recommendations. It also suggests the highest quality layers, or “tranches”, of debt should count towards banks’ liquid assets able to be sold in a crisis to raise cash, helping them meet another international regulatory requirement.

Oh boy.

via Five takeaways from the Treasury’s deregulation report

Watchdog’s MetLife Blunder Boosts Systemic Risk

If MetLife’s escape from too-big-to-fail scrutiny leads to a rush for the exits by more obvious financial time bombs, regulators only have themselves to blame.

The country’s largest insurer just convinced a Federal court that the Financial Stability Oversight Council’s designation of it as a “systemically important financial institution” under the post-Crisis Dodd-Frank rules was arbitrary and capricious.

The details of the ruling, handed down on March 30, are sealed until April 6, but other non-bank SIFIs are already straining at the leash.

GE filed an application with the FSOC today to have its SIFI status removed. It and MetLife are two of four non-bank SIFIs – the other two are Prudential and AIG. Prudential has kept mum on its plans; AIG – the near-death experience of which was one of the most painful pain points of the Crisis – hasn’t a prayer. Its $180 billion government bailout and de facto nationalization saw to that.

In 2013 and 2014 the FSOC, a panel of financial regulators set up under Dodd-Frank in large part to oversee potential basket cases, lumped these four in with more straightforward financial time bombs – investment banks and commercial banks like Goldman, JP Morgan, Citi and others. From the FSOC’s statement at the time:

Under Section 113 of the Dodd-Frank Act, the Council is authorized to determine that a nonbank financial company’s material financial distress—or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities—could pose a threat to U.S. financial stability. Such companies will be subject to consolidated supervision by the Federal Reserve and enhanced prudential standards.

GE boss Jeff Immelt never claimed that GE Capital – once the biggest commercial paper issuer and the entity that generated over half the financial-industrial behemoth’s sales at its height – wasn’t systematically important. He has spent the last couple of years slashing GE Capital assets by some $160 billion, reducing its contributions to revenues from half to just under 10 percent.

The MetLife court case is the real problem for FSOC. It seems from MetLife’s complaint, and the bits and pieces reporters have gleaned from the court ruling, that FSOC failed to make a convincing argument that the insurance business model was subject to capital pressure due to customers’ “running for the exits” – akin to a run on a bank – and that this vulnerability threatened the financial system due to the firm’s size and interconnectedness. Bloomberg View’s Matt Levine has a run-down on the argument here. MetLife also claims the FSOC never did a vulnerability analysis. If so, that’s at best sloppy and at worst terribly arrogant regulatory behavior.

Step back for a second. MetLife says its business model is not subject to runs because it issues long-term liabilities (insurance policies) that customers cannot cash in at will. But FSOC, if anyone’s awake there, knows the trouble isn’t with the firm’s liabilities, it’s with its assets.

This is an industry wide problem. Insurance margins have been crushed by low rates; the need to shimmy further and further down the credit spectrum in search of yield has been tempting. Like banks making mortgages, insurers are in the maturity transformation business – borrow short, lend (or insure) long, and hope to the gods things add up in the end.

That’s where the risk in an institution like MetLife lurks. But it’s not a contagious risk. If assets fall short of liabilities, shareholders get screwed first, then, perhaps, policyholders, although that would be almost unthinkable with a firm of MetLife’s size.

So by designating MetLife a non-bank SIFI, regulators did two things. First, they stretched the rationale for such a designation to the point where the firm was able to blow it up in court (against expectations – MetLife was so sure of losing it had begun to execute plans to spin off many of its business lines). And as a result, they gave the anti-regulation camp a shot in the arm – and that could lead to more systemic risk, not less.