Garrett Op-Ed in The Hill: Derivatives wrongly named as key culprit in system breakdown
Washington,
Jul 23 -
Derivatives wrongly named as key culprit in system breakdown
By Rep. Scott Garrett (R-N.J.)
http://thehill.com/op-eds/derivatives-wrongly-named-as-key-culprit-in-system-breakdown-2009-07-22.html
In the popular dialogue about derivatives, opinion often masquerades as fact. Derivatives have been demonized by many who unfortunately choose to perpetuate myths about these products, instead of developing the sophisticated understanding of how they work that serious policymaking demands. In order to do justice to the taxpayers who have funded over a trillion dollars in bailouts, as well as the thousands of businesses and investment managers that rely on derivatives to manage risk, it’s important to dispel these myths and understand the nuanced reality of both the perils and the benefits these financial products provide.
These myths extend to the over-the-counter (OTC) derivatives markets as a whole, oftentimes failing to take into account the wide variety of products available to firms within the OTC market, and threaten to apply a sledgehammer where a scalpel is needed. In reality, derivatives played a limited role in the current financial crisis, and the knee-jerk reaction to mandate clearing for all derivatives products and apply bank-like regulations to non-bank market participants threatens to create serious harm not only to financial markets but more importantly to thousands of non-financial companies that America needs to create economic growth.
One prominent myth that persists in conventional wisdom is the idea that the failure of Lehman Brothers caused the cardiac arrest of American International Group because of the derivatives exposure AIG had to Lehman in the form of credit default swaps (CDS). In reality, in the month following Lehman’s bankruptcy, its derivatives contracts were settled and AIG had to pay out a comparatively small $6.2 million on its Lehman exposure. Additionally, the Federal Reserve issued a statement on its reasoning for rescuing AIG, which highlighted “market fragility” as its cause for intervention, not derivatives. AIG’s failing health was ultimately attributed to the company’s failure to appropriately assess the risks of its portfolios of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
Nevertheless this myth, which plays so prominently in the narrative of those seeking to apply ill-suited and outmoded types of regulation to OTC derivatives, has embedded itself in our collective account of the economic crisis and the bailouts that followed.
The truth about the financial crisis is that poor housing finance, misguided regulatory policy and lax oversight were among the primary contributors to the economic turmoil. Too many mortgage loans were made to individuals who ultimately couldn’t afford to make their payments, and regulators failed to appropriately identify the risk of such loose lending standards. Whether the losses came on mortgage loans, mortgage-backed securities, or credit default swaps that guaranteed mortgage-backed securities, the underlying problem was as basic as it is pervasive: too much money was loaned to too many people who couldn’t repay it. The regulatory policies and distorted incentives that created this crisis are unfortunately still with us, and fixing them will require a commitment to upset established constituencies and some politicians’ longtime supporters. One thing we know for sure is that creating a new regulatory structure for derivatives will do nothing to address the real problem. This issue is not resolved by attacking derivatives.
Furthermore, rather than contributing to risk, derivative products are important innovations for companies looking to appropriately manage their risk. They not only allow financial institutions to hedge and diversify exposure stemming from credit, interest rate, and currency risk, they allow for the transformation of credit from an illiquid risk to one that can be traded in ways similar to other types of assets. The ability of financial firms to trade risk means that there is a market for companies that don’t want it. These companies can use derivatives to remove the unwanted risk from their operations in order to focus on their core business. The use of derivatives spans multiple industries including manufacturing, exporting, agribusiness and energy. By using derivatives, companies can provide consumers protection against energy and food price spikes. Good risk management reduces costs for consumers, increases economic growth, and creates more jobs.
Over-regulation or improper regulation that might sound good politically could have major, unintended negative consequences, not just for our financial markets, but for our broader economy. Rather than reducing risk, poor regulatory policy masquerading as “reform” could exacerbate it. Mandating clearing for all derivatives contracts and applying bank-like regulations to derivatives dealers are the two most frequently mentioned options for derivatives regulation. Mandating the use of central clearinghouses for derivatives contracts has the potential to restrict liquidity in the marketplace, limit the ability of businesses to hedge their unique risk and tie up capital that could be used to promote business development. In addition to mandating clearing, the regulatory reform plan advocated by the Obama administration and supported by House Democrats extends heavily flawed banking-style regulations to businesses that use derivatives by applying capital requirements, business conduct rules, and margin requirements.
As we explore additional solutions to the financial crisis, we must acknowledge and explore the deficiencies of these regulations that oversee our country’s banking industry. It is nonsensical to limit a business’s ability to manage risk by imposing a regulatory framework on derivatives users that failed to provide stability and soundness for banks.
Congress must not be overwhelmed by the fact that one high-profile financial institution, AIG, made a bad investment decision, using a financial product like derivatives to guarantee mortgages that went sour. This, of course, occurred while under the supervision of their regulator, the Office of Thrift Supervision (OTS). We must make a thoughtful examination of these products and their uses to understand what went wrong, and come to a conclusion of the best way to fix our financial markets. We must do our due diligence and create an effective reform of financial services regulation that protects against the worst abuses of some market participants while preserving the ability of American business to use derivatives to manage their financial risks. No doubt greater expertise among regulators is required, a notion reinforced by the fact that AIG was a regulated entity.
The goal of financial services regulatory reform must be to achieve financial stability. This process should not be viewed as an opportunity to restrict innovation or exact punitive regulations on financial products that did not cause the crisis.
Garrett is the ranking member of the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises for the House Financial Services Committee.
