Part 9 (1/2)

A solution would be to mandate that all institutional investors pay into a coulators For every new issuance of debt, this pool would be used to purchase ratings froencies This solution would require that all players in the financial systee funds-contribute to the pool

This requireencies, but that's precisely the point: the idea that the issuers of debt pay for their ratings is bizarre To return to our earlier analogy, it's corade Iine that students have a choice of professors (just as debt issuers have soencies) Those professors who hand out lots of Fs will soon find that theirbut As-are attracting more students and more revenue But all those As will be just as spurious as the AAA ratings handed out at the height of the housing bubble

Make no encies will be no easy task; they occupy a unique place within the financial fir reforms are put in place, the conflicts of interest will almost certainly continue

But let's assume for a moment that those conflicts can be encies henceforth bestow accurate ratings on things like s agencies will touch the opaque,instru with Derivatives

In 2002 Warren Buffett penned a now-legendary annual report to investors in Berkshi+re Hathaway He decried the growing use of derivatives, which he ominously described as ”time bombs, both for the parties that deal in them and for the econo derivatives as ”financial weapons of ers, he warned, ”that, while now latent, are potentially lethal” Most presciently of all, he warned that ”the derivatives genie is noell out of the bottle, and these instruments will almost certainly multiply in variety and number until soht, but the story is a bit more complex Derivatives have been around for several centuries; not until recently did they assulobal financial system After all, a derivative is simply a bet on the outcome of some future event: a movement in interest rates, oil prices, corn prices, currency values, or any nuo by various names-swaps, options, futures-and they've worked just fine for decades, enabling people to ”hedge” against risk In their original iteration, farainst fluctuations in the prices of their crops in advance of a harvest, giving them peace of mind they would otherwise lack

But in recent years derivatives have grown into soether different, thanks to the rise of several new varieties, such as the credit default swap (CDS) This instrument has been compared to an insurance contract but was in fact very different It superficially did resemble insurance in that it allowed a buyer to purchase protection in the event that a debtor defaulted on his obligations If that happened, the seller of the ”insurance” would be on the hook to help the buyer recoup his losses However, unlike the purchaser of an insurance contract, the purchaser of a CDS didn't have to actually own a chunk of the asset that was the subject of the bet Worse, anyone who had placed a bet that someone would default had every incentive toa CDS was akin to buying homeowners' insurance on a house that you didn't actually own-and then trying to set fire to it

The CDS e By the time the crisis broke in 2008, the notional value of CDSs (the a insured) topped out at 60 trillion Much of the credit-or blame-for their meteoric rise lies with free-market zealot Senator Phil Gra Coed to insert a provision in the Commodity Futures Modernization Act that exeulation by the Co Commission (CFTC)

The key phrase here is ”over the counter” (OTC) It ht seem to be the opposite of ”under the table,” but in fact ”under the table” is as good a definition as any of an OTC transaction OTC transactions are ones in which the derivative contract is signed by two private parties-typically a ”bilateral contract,” to which no one else is privy The lack of transparency is complete: no one knows the extent of anyone else's exposure, much less where it's concentrated The financial firms that created many of these instruments were all too happy to keep the details secret; after all, their trading strategies were proprietary infor the crisis this secrecy proved corrosive to investor confidence

No less troubling was ”counterparty risk”: the chance that the institutions that had sold this ”insurance” would be unable toa systemic financial crisis That's precisely what happened as the recent crisis gathered steam: major financial institutions, confident that they would never have to pay, didn't set aside the necessary reserves This posed a risk to the entire financial system, particularly in the case of AIG, which had insured-via CDS transactions-over a half trillion dollars' worth of toxic CDO tranches AIG was in no position to cover the losses on these tranches, and because its failure would have bankrupted the firovernment stepped in and bailed it out In effect, counterparty risk created a financial syste to fail, but too interconnected to fail

Derivatives have been associated with a number of other infamous episodes in financial stress and crisis For example, a kind of derivative known as portfolio insurance was implicated in the 1987 stock ht Orange County, California, to the brink of bankruptcy Derivatives played a ravated the boo 2008 and 2009 Derivatives can wreak havoc in other ways as well, hiding liabilities, avoiding taxes, frustrating atte as adefaults of banks, fir derivatives ood idea But it's not: most derivatives operate without ill effect What we need to do is control the excesses that certain derivatives can cause As with everything else in this mess, that's easier said than done; there is no panacea But some sensible steps should be taken immediately

First we must correct the proble been traded over the counter without problems-like plain-vanilla interest-rate swaps and currency swaps-and could reasonably reether These orous regulation by the SEC and the CFTC The Oba these lines, and several proposals to ulation a reality are already on the table

One school of thought advocates forcing credit derivatives onto the kind of central exchange siht and sold This idea uarantee that derivatives will be cleared and settled in a straightforward, transparent fashi+on Such a new institution could also ensure that the parties to derivatives have the necessary collateral to ood on their pro credit derivatives could be standardized and traded on such a central exchange, not all of them can be: many of the OTC derivatives are next to impossible to standardize and are not traded in sufficient volumes; their price can't be consistently quantified like a stock or bond (or a common derivative)

These istered in a central clearinghouse Such institutions already exist for other, si Corporation, for example, handles a host of derivatives related to equities and coanization, it has the imprimatur of both the SEC and the CFTC Part of its job is to make certain that the parties to a derivatives contract have sufficient collateral to ood on their promises (In other words, no financial fir sufficient collateral) In return, the clearinghouse would assume the burden of the contract in the event the counterparty failed All this helps reduce the probleood idea, a few caveats are in order First, if the houseit to default too To soin requirements Nonetheless, as recent events have shown, it's easy to underestihouse would necessarily operate under the scrutiny of regulators, ould be charged withsure that it had the necessary reserves to ride out a store: if the clearinghouse handles only straightforward, standardized credit derivatives, financial engineers are likely to deliberately create exotic derivatives that the clearinghouse cannot accoulation Far better to have the clearinghouse handle all such derivatives

This solution could go hand in hand with other reforms to increase transparency For exaistered in a central database that would be accessible to the public As our colleagues at New York University have suggested, that sort of data collection could be ine (TRACE), the database adulatory Authority Making thesepricing aher prices than market conditions warrant

In soether, or severely restricting their use For exa CDS contracts entirely One of the cardinal rules of insurance holds that the party purchasing the policy must have an ”insurable interest”: a direct stake in the outcome Most CDS contracts dispense with this custoy: CDS contracts effectively gave Wall Street ”huge incentives to burn down your house,” as one reporter for the Financial Tiht, insurance couarantees The only ones trafficking in these instruh-risk players in the financial in and collateral requireet into the insurance business, it should be required to demonstrate beyond a shadow of a doubt that it will be able to ations

One final ulation of derivatives would entail changing the relative responsibilities of the SEC and CFTC These agencies regulate different slices of the derivatives ulatory authority Consolidating the responsibility for overseeing all derivatives within a single agency would per derivatives and,the potential threat they pose to the stability of the international financial system

These sorts of reforms would address several problems: counterparty risk, a lack of price transparency-even the outsize fees that are a feature of the mysterious market in over-the-counter derivatives and that enable insiders to reap enorestions are not a cure-all Derivatives are aulate and rowth over the last decade has onlyarisk to a purely speculative instruers, for exae and risk Increasingly exotic, opaque, and ier to the financial syste reforeneration of derivatives should be the subject of far ulators Put differently, this is not a situation where regulators need to fear that cracking down on these instrurowth Far froer to global econoislators, policy ulators understand that, the better

Unfortunately, that stability has to be shored up ide That uidelines that shape how banks do business too

Basel and Beyond

The quaint Swiss city of Basel has many claims to fame: the oldest university in Switzerland, the country's first zoo, and,Basel's schools have been hoiants like Friedrich Nietzsche, and its storied cheiven the world everything froiven the world so but no less i Supervision

Born in 1974, this little-understood institution draws its members from central banks of the advanced economies known as the G-10 Its ulate and supervise banks and other financial institutions While its recoreat deal of weight Much of the financial system as it existed on the eve of the crisis was a creature of the Basel Couidelines, or accords, have evolved over the years The first accord, the Basel Capital Accord, known as Basel I, asked banks to differentiate between the various classes of assets they held in order to better assess the relative risk posed by holding them This risk assessment would affect how much capital a bank had to hold

Consider two hypothetical banks, each of which borrows a billion dollars from other sources and invests it One invests in low-risk, supersafe US Treasuries, the other in high-risk corporate junk bonds Under the Basel I guidelines, the two banks would assign a different risk factor (a percentage) to these different assets This risk factor would guide how much capital they had to hold relative to these risks In practice the bank with the supersafe government debt didn't need to hold as much capital as the bank with its money in junk bonds

Basel I had a few other stipulations Banks that operated in multiple countries had to hold capital equivalent to 8 percent of their risk-weighted assets In an additional wrinkle, the guidelines spelled out the form that this capital or equity could take: coh-quality capital (called Tier 1 capital), and everything else (Tier 2 capital)

The first Basel accord went into effect in the 1980s, and by 1992 ing-uidelines too, as a demonstration of financial stability and prudence Unfortunately, standards that made sense for advanced industrial econo economies to maintain, particularly in ti

No less troubling, bankers had found ways to hide risk that Basel I did not anticipate-for exaave bank balance sheets the appearance but not the reality of stability Bankers had obeyed the letter but not the spirit of the Basel I guidelines

These failures led to Basel II While its predecessor had filled a es, the new accord was aluidelines on weighing the relative risk of various assets; suggestedthese calculations; expanded the definition of risk to encoht fall in value on the open ht to close various loopholes by which banks had hidden risk; urged regulators to ressively to monitor compliance with capital reserve requirements; and spelled out terms by which banks would h many European nations wanted Basel II to apply to all banks, the United States, Canada, and the United Kingdoe international banks

The members of the G-10 hammered out a final version of Basel II in 2006 It then went to the individual nations for implementation, a process that was under hen the crisis hit It immediately became apparent that for all its specificity, Basel II had serious flaws Although many of the revisions were a response to the crises of the 1990s, Basel II did not protect large banks from the kind of disruptions that attend a major financial crisis Simply stated, Basel II assumed that the world's financial system was more stable than it actually was This was a serious mistake

The crisis underscored several realities One, banks needed higher-quality capital and more of it Two, the ”capital buffer” that h to shelter the bust and the credit crisis Three, the quality of the capital as defined by Tier 1 and Tier 2 could deteriorate significantly in a ti Basel II will take years, but a few things stand out For starters, the way Basel II defines and ranks capital should be changed Rather than relying on the Tier I definition to calculate bank capital, it ible Common Equity (TCE) TCE counts only common shares in its calculation of capital; by contrast, Basel's Tier I capital definition includes both common and preferred shares TCE is thus a more conservative estimate of the capital a bank has on hand As such, it may be a more realistic way to assess a bank's health in the face of a crisis

There's a deeper problem with the way that Basel II is structured The methods it used to calculate capital had the perverse effect of exaggerating the a boo the opposite when the crisis hit, causing them to curtail their exposure to risk in excessive and disruptive ways This happened because during boom times the price of assets held by the banks rose, si them to take on more risk In the crisis, the process went into reverse: asset prices fell, and suddenly the banks needed more capital just when it was most difficult to obtain